15th Apr 2005 11:59
Telefonica SA15 April 2005 PART 2 Notes to the English version: Free translation of a report originally issued in Spanish In the event of discrepancy, the Spanish Language version prevails This report does not express an opinion on the fairness of the transaction, the value of the security or the adequacy of the consideration to shareholders Independent expert report in relation to the plan for the merger by absorption of Terra Networks, S.A. by TelefOnica, S.A. KPMG Auditores, S.L. This report contains 28 pages Ref: 05m31abm1.doc To the Directors ofTelefonica, S.A. andTerra Networks, S.A. Pursuant to the provisions of article 236 of the Revised Text of the SpanishCorporations Law Ms. Eloisa Bermejo Zofio, Mercantile Registrar number IV forMadrid and its province, appointed KPMG Auditores, S.L. as independent expert toprepare this single report regarding the plan to carry out a merger byabsorption of Terra Networks, S.A. by Telefonica, S.A. (hereinafter jointlyreferred to as the Companies) and about the net equity contributed by thecompany that will disappear and, in particular, as to whether or not the shareexchange ratio is justified, the methods that have been used to calculate it andwhether these are appropriate, stating the values determined and any specificvaluation difficulties that may exist, as well as stating whether the net equitycontributed by the company that will be dissolved is at least equal to theincrease in share capital of the acquiring company. 1 Description of the Transaction 1.1 Identification of the entities participating in the merger • Telefonica, S.A. (hereinafter Telefonica) Telefonica, domiciled in Madrid, at Gran Via, 28, was incorporated for anindefinite period by means of a notarial instrument executed before Mr.Alejandro Rosello Pastor, a Madrid Notary, on April 19, 1924, at entry No. 141in his notarial register. Telefonica is registered with the Commercial Registry of Madrid, in Book 12.534,Folio 21, Page M-6.164. Telefonica's Taxpayer ID number is A-28.015.865. • Terra Networks, S.A. (hereinafter Terra) Terra, domiciled in Barcelona, at Nicaragua, 54, was incorporated for anindefinite period as Telefonica Comunicaciones Interactivas, S.A. by means of anotarial instrument executed before Mr. Jose Antonio Escartin Ipiens, a MadridNotary, on December 4, 1998, at entry No. 5,276 in his notarial register, andchanged its name to the current one by virtue of an instrument dated October 1,1999, drawn up before Mr. Francisco Arriola Garrote, a Madrid Notary, andrecorded under entry No. 1,269 in his notarial register. Terra moved to itscurrent domicile by resolution adopted at the ordinary general shareholders'meeting held on June 8, 2000, converted into a public instrument before Mr.Nicolas Ferrero Lopez, a Notary of Pozuelo de Alarcon, on August 3, 2000, andrecorded under entry No. 2,893 in his notarial register. Terra is registered with the Commercial Registry of Barcelona, in Book 32.874,Folio 165, Page B-217.925. Terra's Taxpayer ID number is A-82.196.080. 1.2 Merger share exchange ratio In accordance with the Merger Plan prepared by the boards of directors ofTelefonica and Terra (hereinafter, the Plan or the Merger Plan), approved onFebruary 23, 2005, the exchange ratio for the shares of the entitiesparticipating in the merger, which was determined by the Boards of Directors ofTelefonica and Terra on the basis of the actual value of the corporate assetsand liabilities of Telefonica and Terra, will be as follows (with nosupplemental cash compensation): Two (2) shares of Telefonica, each having a par value of one euro (euro1), for every nine (9) Terra shares, each having a par value of two euro (euro 2). The dividends that both companies plan to distribute (see section 1.6) have beentaken into consideration in determining the share exchange ratio. Furthermore, as mentioned in the Plan, Morgan Stanley & Co. Limited,(hereinafter Morgan Stanley) as Telefonica's financial advisor for thistransaction (hereinafter, the Transaction) has expressed to the company's boardof directors in its fairness opinion that the agreed-upon exchange ratioto be paid by Telefonica was fair from a financial point of view to Telefonica'sshareholders. For their part, Lehman Brothers Europe Limited International(Europe), Spanish Branch, (hereinafter the Lehman) and Citigroup Global MarketsLimited, (hereinafter the Citigroup) as Terra's financial advisors for theTransaction, have expressed to the latter company's board of directors in theirfairness opinion that from a financial point of view the agreed-uponexchange ratio is fair for the shareholders of Terra other than its majorityshareholder, Telefonica. 1.3 Merger balance sheets For the purposes set forth in Article 239 of the Revised Text of the SpanishCorporations Law, the balance sheets for the merger shall be deemed to be theindividual balance sheets of Telefonica and Terra as of December 31, 2004. Thesebalance sheets were prepared by the respective boards of directors on February23, 2005 and verified by the auditors of both companies and will be submittedfor the approval of the shareholders at the general shareholders' meetings ofeach of the companies that must decide on the merger, prior to the adoption ofthe merger resolution itself. The merger balance sheet as at December 31, 2004 of Telefonica has been auditedby Deloitte, S.L. who issued an unqualified audit report thereon dated March 4,2005. The merger balance sheet as at December 31, 2004 of Terra has been audited byDeloitte, S.L who issued an audit report on the individual annual accounts datedFebruary 24, 2005 including the following emphasis paragraphs which aretranscribed literally: "3) Since the Company is the head of a group and meets certain requirements, it is obliged under current legislation to prepare separate consolidated financial statements, on which we issued our auditors' report on this same date which was qualified for the same uncertainty as that described in paragraph 5 to this report. The effect of consolidation, which was performed on the basis of the individual accounting records of the companies composing the Terra Group, with respect to the individual financial statements referred to above, was to decrease assets and the income for the year by & euro;303,399 thousand and euro26,945 thousand, respectively, and to increase reserves by euro27,717 thousand (see Note 4-c to the financial statements referred to above). 4) On February 23, 2005, the Board of directors of Terra Networks, S.A., approved the plan for the merger of Telefonica, S.A. and the Company. This merger has not yet been approved by the respective Stockholders' Meetings. In this connection, the financial statements referred to above were prepared without taking into account the effects, if any, that could arise from the aforementioned merger. As of December 31, 2004, the "Long-Term Investments" caption included a balance of euro287,009 thousand, relating to prepaid income taxes and tax assets capitalized for tax losses incurred in 2001 and prior years (see Note 9). The directors of Terra Networks, S.A. consider that, subject to the materialization of certain circumstances and the fulfillment of certain assumptions, and based on the projections and business plans prepared by their external advisers for the next ten years, in the context of the aforementioned merger, this amount is recoverable in the aforementioned period of time. In view of the nature of any business plan, which is based on future expectations, significant differences may arise between the projected and actual results. Management of Terra Networks, S.A. intends to update the plan every year and, in any case, whenever the evolution of the business makes this necessary." The report also includes the following qualification: "5) As indicated in Note 14-d)1, as of the date of this Auditors' Report no decision had yet been handed down in relation to the claim for damages of an unquantified amount, filed by IDT (International Discount Telecommunications Corporation) against Terra Networks, S.A., Terra Networks USA, Inc. and Telefonica, S.A. The Company's directors and their external legal advisers consider that Terra Networks, S.A., has solid arguments on which to oppose the claims; although at the present stage of the proceedings they consider that they cannot predict the final outcome thereof." 1.4 Maximum increase in capital of Telefonica The Merger Plan states that, at the date of the Plan, Telefonica held fourhundred and thirty-six million two hundred and five thousand fourhundred and nineteen (436,205,419) Terra shares, representing seventy five pointeighty seven percent (75.87%) of the share capital. The share capital of Terra is represented by 574,941,513 shares. The report alsostates that at that date, Terra held seven million (7,000,000) treasury stock,which were allocated for redemption following the amendment of the hedgingsystem for the various Terra stock option plans for employees and management.The above-mentioned seven million (7,000,000) shares will not be part ofthe exchange, in compliance with the provisions of Article 249 of the RevisedText of the Spanish Corporations Law and similar provisions, although, followingthe registration of the merger, Telefonica will succeed Terra as the entitybound by such plans, which will be amended in accordance with the share exchangeratio established in this Plan. To avoid prejudice to the interests of thebeneficiaries of these plans, Telefonica will establish, if necessary,mechanisms to ensure that due attention will be given to the commitments assumedby Terra in connection with the above-mentioned stock option plans. Considering that the share capital of Terra is represented by 574,941,513 sharesand that at the date of the merger Terra will hold 7,000,000 treasury stock, themaximum number of Terra shares that may be subject to the exchange would be131,736,094 and, therefore, the maximum number of Telefonica shares to beconveyed to the Terra shareholders in the exchange would amount to29,274,687.555. Considering that the shares are indivisible and that fractions of shares cannotbe issued or conveyed, it is imperative that the total number of Terra shares onthe market for the share exchange must be a multiple of the share exchange ratiofor the exchange to be properly carried out. Consequently, Telefonica plans toacquire seven additional Terra shares. In this case, the maximum number ofshares necessary to perform the share exchange would be 29,274,686. The Plan states that, if necessary, Telefonica will increase its share capitalby the exact amount needed to make the exchange for Terra shares in accordancewith the exchange ratio established in the Merger Plan. The increase would be carried out through the issuance of the precise number ofshares, each having a nominal value of one euro (euro1), belonging to the samesingle class and series as the current Telefonica shares, as represented by book-entry accounts, with the application, in any event, of the provisionsof Article 249 of the Corporations Law. In particular, the Terra shares held byTelefonica will not be exchanged, and will be cancelled. The difference between the net book value of the assets and liabilities receivedby Telefonica by virtue of the merger covered by the Plan and the par value ofthe new shares issued by Telefonica - adjusted, if necessary, by the proportionrepresented by the new shares of the total shares delivered in exchange - shallbe treated as share issuance premium. Both the par value of such shares and the corresponding share issuance premiumshall be entirely paid-up as a result of the en bloc conveyance of thecorporate assets and liabilities of Terra to Telefonica, which, throughuniversal succession, shall acquire the rights and obligations of Terra. Based on Terra's individual annual accounts at December 31, 2004, the value ofshareholders' equity of Terra amounted to Euros 1,633,964 thousand at that date.The value of shareholders' equity of Terra, net of treasury stock, at that dateamounted to Euros 1,618,844 thousand. Prior to execution of the merger, Terra plans to distribute a dividend of euro0.60 per share issued with dividend-receipt rights, which should betaken into account in determining the book value of the assets and liabilitiesof Terra that will be transferred to Telefonica. The total amount of thisdividend, considering that Terra's treasury stock currently totals 7,000,000shares, would be Euros 340,765 thousand. Consequently, the total amount of the share capital increase that Telefonicawould be required to make would amount to Euros 29,274,686. The maximum shareissuance premium, calculated on the basis of the net assets and liabilities ofTerra at December 31, 2004 less the total amount of the dividends that Terraplans to distribute prior to the inscription of the merger in the CommercialRegistry would amount to Euros 267,180 thousand. Not withstanding the above, the maximum amount of the capital increase to becarried out by Telefonica pursuant to the established exchange ratio may bereduced through the delivery to Terra shareholders of old own shares held byTelefonica as treasury stock. 1.5 Date from which the shares delivered in exchange will carry the right toparticipate in corporate earnings Shares that may be issued by Telefonica in connection with the capital increasementioned in the previous paragraph, will entitle their owners to participate inthe corporate earnings obtained by Telefonica as from January 1, 2005. Previously existing Telefonica shares and shares delivered or issued inconnection with the exchange will participate, with equal rights in proportionto the par value of each share, in distributions made after the date that themerger deed is recorded with the Commercial Registry. 1.6 Dividends For the preparation of this Merger Plan and the determination of the shareexchange ratio indicated in Section 1.2 above, the boards of directors ofTelefonica and Terra took into consideration the following dividend-payment plans: a. Telefonica plans to make the following distributions: i. Payment of an interim dividend on account of the earnings for the fiscal year ended December 31, 2004, which will be paid on May 13, 2005. This dividend was announced by the board of directors at its meeting held on January 26, 2005 and amounted to euro0.23 per share. As indicated in Section 1.5 above, Terra shareholders who become Telefonica shareholders as a result of the merger will not benefit from this dividend. This has been taken into consideration in the calculation of the share exchange ratio. ii. The distribution of Telefonica's treasury stock, at the ratio of one share of treasury stock for every twenty-five shares owned by the shareholders, to be charged against the share issuance premium. The proposal for this distribution plan was approved by the board of directors at its meeting held on November 24, 2004. The distribution is subject to the corresponding approval by the shareholders of Telefonica at their ordinary general meeting. The payment is expected to be made during the days following the meeting and, in any event, before the merger of Telefonica and Terra is recorded with the Commercial Registry. Terra shareholders who become Telefonica shareholders as a result of the merger will not benefit from such distribution. This was therefore taken into consideration in the determination of the share exchange ratio. iii. The payment of a dividend with a charge against the share issuance premium which should be paid on November 11, 2005. The proposal for this dividend was announced by the board of directors at its meeting held on November 24, 2004. The distribution is subject to the corresponding approval by shareholders at the ordinary general shareholders' meeting of Telefonica. The exact amount of this dividend is expected to be & euro;0.27 per share. Unlike the provisions for dividends described above in subsections (i) and (ii), this dividend will be received by both the Telefonica shareholders and the Terra shareholders who become Telefonica shareholders as a result of the merger. This was therefore not taken into consideration in the determination of the share exchange ratio. b. Terra expects to distribute a dividend of euro0.60 per share, with a charge to the share issuance premium. The proposal for this distribution was approved by the board of directors at its meeting held on February 23, 2005. The distribution is subject to the corresponding approval by the shareholders at the ordinary general shareholders' meeting of Terra. Payment is expected to be made during the days following the meeting and, in any event, before the merger of Telefonica and Terra is recorded with the Commercial Registry. Only the shareholders of Terra will benefit from such distribution. This wastherefore taken into consideration in the determination of the share exchangeratio. 1.7 Date of the accounting effects of the merger January 1, 2005 is established as the date from which the transactions of Terrashall be deemed for accounting purposes to be for the account of Telefonica. 1.8 Administrative authorizations The effectiveness of the planned merger shall be subject to the provision ofnotices and the procurement of the applicable relevant authorizations andregistrations in Spain and in the other jurisdictions in which both companiesare present. 2 Valuation methods used to determine the share exchange ratio A description of the methods followed by the Board of Directors of Telefonicaand Terra to determine the share exchange ratio, based on information receivedfrom these companies, is as follows: 2.1 Telefonica The actual value of Telefonica used by the Board of Directors to determine theshare exchange ratio amounted to euro66,361 million. This amount has beencalculated based on the closing trading price of Telefonica on February 21, 2005(euro14.19 per share), discounting a total of euro0.80 per share. Thisadjustment has been made on the basis of the dividends that Telefonica intendsto distribute prior to registration of the merger and which, accordingly, willnot be attributable to the shareholders of Terra once the share exchange hastaken place. The dividends considered are as follows: (i) a dividend of euro0.23 per share on account of profits for the year ended December 31, 2004, whichwill be paid to the current shareholders of Telefonica on May 13, 2005; and (ii)a non-monetary dividend, with a charge to the share issuance premium, ofone share from Telefonica treasury stock for every twenty five shares held bythe Telefonica shareholders which is planned to be paid immediately after theordinary general meeting of shareholders is held to decide upon the merger. Theestimated value of this dividend is euro0.57 per share. The euro0.27dividend per share that is planned to be paid on November 11, 2005 has not beentaken into consideration in making the adjustment because it will be paidsubsequent to the registration of the merger and, consequently will benefit boththe shareholders of Telefonica and the shareholders of Terra and will thereforenot affect the share exchange ratio. The closing trading price of Telefonica shares adjusted for the aforementioneddividends amounts to euro13.39 per share and, multiplied by a total of 4,956million Telefonica shares amounts to euro66,361 million. The Companies, after consultation with their financial advisors, consider thatthe valuation method based on the market quotation of the company is justifiedgiven the high level of liquidity of Telefonica shares. Based on the information received from Telefonica, management of Telefonicacontracted the services of Morgan Stanley as financial advisors for theTransaction, and to assist Telefonica with the valuation process of theCompanies and Telefonica's determination and justification of the mergerexchange ratio. Appendix I includes the report prepared by Telefonica summarizing the valuationanalyses and the justification of the share exchange ratio prepared byTelefonica with the financial advice of Morgan Stanley. 2.2 Terra The actual value of Terra used by the Board of Directors to determine the shareexchange ratio is euro1,690 million. This actual value has been based on thesum-of-the-parts method, principally based on thediscounting of cash flows, which has been contrasted with the followingvaluation methods: (i) multiples of comparable quoted companies, (ii) multiplespaid in comparable transactions (iii) market quotations, and (iv) target pricesof equity analysts. Furthermore, a dividend of euro0.60 has been discountedwhich Terra plans to distribute prior to the registration of the merger. Theresulting unit value of the Terra share is euro2.98. Based on the information received, Terra contracted the services of Citigroupand Lehman as financial advisors for the Transaction, and to assist Terra withthe valuation process of the Companies and Terra's determination andjustification of the merger share exchange ratio. Appendix II includes the reports prepared by Terra summarizing the valuationanalyses and the justification of the share exchange ratio prepared by Terrabased on the advice of its financial advisors Citigroup and Lehman. 3 Scope and procedures applied in our work Our analyses and confirmations have been carried out solely to comply with therequirements of article 236 of the Revised Text of the Spanish Corporations Law.The following procedures have been employed in our work: 3.1 Procurement and analysis mainly of the following information: • The Merger Plan of February 23, 2005 formulated and approved by the boards of directors of Telefonica and Terra. • Certificates of agreements of the boards of directors of Telefonica and Terra relating to the approval of the Merger Plan of February 23, 2005. • Fairness opinions and valuation analysis documents on the Companies prepared by Morgan Stanley & Co. Limited, Lehman Brothers International (Europe), Spanish Branch and Citigroup, upon request of the respective boards of directors of the respective Companies. • Information prepared by Terra and Telefonica in reply to the information required by the CNMV relating to the merger transaction dated February 25, 2005 and March 23, 2005. • Individual and consolidated audited annual accounts of Telefonica and Terra for the years ended December 31, 2003 and 2004, audited by Deloitte, S.L. Audited annual accounts of Terra Networks Espana, S.A., Sociedad Unipersonal for the year ended December 31, 2004 audited by BDO Audiberia Aduitores, S.L. • Strategic Plan of Terra for the period from 2005 to 2008 both inclusive. • Budget for Terra in respect of 2005. • Financial projections of the statements of profit and loss of Terra prepared by management for the period from January 1, 2005 to December 31, 2008. • Analytical financial information for Terra, by line of business, for the years ended December 31, 2003 and 2004. • Financial projections of the statements of profit and loss of Telefonica prepared by management for the period from January 1, 2005 to December 31, 2008. • Tax and legal reports relating to the planned merger, prepared for or by the management of each Company. • Strategic Alliance Framework Agreement signed between Telefonica and Terra. • Other commercial and shareholder contracts of the Companies, including those relating to options and binding offers for the purchase/sale of significant shareholdings or those under negotiation, which were considered relevant to the performance of our work. • Stock exchange information on the quotations of Telefonica and Terra shares. • Stock exchange information on shares of companies comparable to Telefonica and Terra. • Public information on transactions concerning shares of companies with similar activities to those of Terra and Telefonica or any of their businesses, where appropriate. • Financial reports prepared by equity research analysts on Telefonica and Terra. • Other information considered relevant to our work. 3.2 Review and analysis using available information of each of the valuationanalysis documents and the Fairness Opinions provided by the respectiveinvestment banks. 3.3 Review of the valuation methodologies employed and the respectiveparameters used by the Board of Directors to determine the share exchange ratiofor the projected merger, with available supporting documentation. 3.4 Sensitivity analysis of the most significant variables which couldaffect the business of the Companies and, consequently, their estimated valuesand the corresponding share exchange ratio. 3.5 Meetings with management of both Companies and their advisors andauditors to gather other information, where applicable, which may be consideredrelevant to our work. 3.6 Procurement of a letter signed by the management of each Company confirmingthat, to the best of their knowledge, we have been provided with all informationconsidered relevant for the preparation of our independent expert report, andthat no other events have taken place between the date of the auditors' reportsof Telefonica and Terra for the year ended December 31, 2004 and the date of ourreport that have not been brought to our attention and which may substantiallymodify the true and fair view of the Companies' net equity and/or financialposition at that date and, consequently, affect the merger share exchange ratio. Our work has been based on audited and/or unaudited information provided byManagement of the Companies. For the purposes of our work we have assumed thatthis information is complete and accurate, and that it reflects the Companies'Management's best estimates of the future operating and financial prospects ofthe businesses. Our work has also been based on information taken from public sources. However,our work did not include contrasting this information with external evidence.Nonetheless, we have confirmed, to the extent possible, that informationprovided is consistent with other data that has been provided to us during thecourse of our work. We have assumed that all the required authorisations and registrations in Spainand other jurisdictions, in which the companies are present necessary to carryout the proposed merger transaction will be obtained without any adverse effectto Telefonica or Terra or the expected benefits of the merger transaction whichcould have a significant effect on our analysis. We would also point out that our work is of an independent nature and thereforedoes not represent any kind of recommendation to Companies' management,shareholders or to third parties in relation to the position which should betaken regarding the planned merger Transaction or other transactions involvingthe Companies' shares. Our work does not address the relative merits of thecurrent or past business strategies of the Companies or the planned mergertransaction as compared to other business strategies or transactions that mightbe available to the Companies, nor does it address the underlying businessdecision of the Companies to proceed with the proposed merger transaction. 4 Special valuation difficulties 4.1 In addition to objective factors, all valuation work involves subjectivefactors which require the use of judgment. Consequently, the "value" obtainedrepresents only a point of reference for the parties interested in carrying outa transaction. It is therefore not possible to provide assurance that thirdparties would necessarily agree with the conclusions reached. 4.2 It should also be taken into consideration that, in the context of anopen market, different prices could exist for a particular business due to anumber of subjective factors. 4.3 The discounted cash flow method used, among others, by the Companies andtheir financial advisors for the valuation of Terra and Telefonica has beenbased on the financial projections of the Companies prepared in accordance withthe assumptions determined by the Companies' management, comprising their bestestimates and judgments based on current circumstances and expecteddevelopments. Given the uncertainties inherent in any information concerning thefuture, certain assumptions may not materialize as initially defined andunexpected events could occur. It should be also taken into consideration thatTerra forms part of the Telefonica group and the policies of both companiescould therefore be more closely inter-related. Considering both of thesecircumstances, the estimated results and cash flows may not materialize asdefined. If Telefonica were not a shareholder of Terra, the results and cashflows could differ from those used and the values obtained could therefore beaffected. 4.4 Based on the information received in relation with Terra's sale of itsparticipation in Lycos Inc. in 2004, Telefonica is considering the possibilityof reporting additional tax losses for the 2004 tax year, under the procedureestablished in the third additional provision of Royal Decree 1163 of 21September 1990, up to a maximum additional amount of euro7,418 million. Theadditional tax loss carried forward would arise as a result of using, as the taxacquisition value of the shares in Lycos Inc, their fair market value atacquisition date rather than their net book value at which they were accountedfor. Although, based on the interpretation of applicable tax legislation,certain technical arguments exist to support the rectification of the income taxreturn to claim the additional tax losses, the absence of identical or similarprecedents that permit their application gives rise to reasonable uncertaintiesas to their possible acceptance by the tax authorities and, consequently, thepossible effective use of such tax credits by the consolidated tax group ofTelefonica, as well as the period in which these tax credits would becomeavailable for use. 4.5 We would point out that in accordance with information obtained and meetingsheld it is not possible to reliably estimate the terms or probability of renewalof the Strategic Alliance Framework contract between Telefonica and Terra datedFebruary 12, 2003 when it expires on December 31, 2008. By virtue of thiscontract Telefonica guaranteed Terra a minimum margin of euro78.5 million perannum until December 31, 2008 measured as the difference between the incomeresulting from the services rendered as a result of this agreement and thedirectly associated costs and investments. 4.6 The audit report on the consolidated annual accounts of Terra for the yearended December 31, 2004 included the following qualification: "5) As indicated in Note 17-d)1, as of the date of this Auditors' Report no decision had yet been handed down in relation to the claim for damages of an unquantified amount, filed by IDT (International Discount Telecommunications Corporation) against Terra Networks, S.A., Terra Networks USA, Inc. and Telefonica, S.A. The Company's directors and their external legal advisers consider that Terra Networks, S.A., has solid arguments on which to oppose the claims; although at the present stage of the proceedings they consider that they cannot predict the final outcome thereof." Consequently, the estimated range of values might have been affected had theoutcome of the current uncertainty regarding this claim been known. 5 Conclusions Based on the work carried out, with the sole purpose of complying with article236 of the Revised Text of the Spanish Corporations Law and considering thosematters described in section 4 above, we consider that: • The valuation methodologies used by the Board of Directors to determine the actual value of the Companies are appropriate in the context and the circumstances of the proposed transaction, and justify the share exchange ratio proposed in the Merger Plan. • The net equity transferred by the company that will be dissolved is at least equal to the maximum increase in capital of the acquiring company as foreseen in the Merger Plan. Our conclusion should be interpreted within the context of the scope of ourverifications, which does not include responsibilities other than those relatingto the reasonableness of the methods employed and the proposed share exchangeratio. This report has been prepared exclusively to comply with the provisions ofarticle 236 of the Revised Text of the Spanish Corporations Law and should notbe used for any other purpose. /s/Ana Martinez Ramon Partner 12 April 2005 Appendix I Telefonica engaged Morgan Stanley & Co. Limited (hereinafter Morgan Stanley) toprovide financial advisory services, including the assistance to Telefonica inthe valuation of the companies, and the determination of the proposed mergerexchange ratio. On February 23, 2005 Morgan Stanley rendered a fairness opinionto the Board of Directors of Telefonica in relation to the Transaction, in whichit concluded that, based upon and subject to the considerations set forth in thesaid document, the exchange ratio to be paid by Telefonica and the extraordinarydividend of euro0.60 per share to be distributed by Terra to its shareholderspursuant to the Merger Plan were fair from a financial point of view forTelefonica. Telefonica determined the financial terms of the Transaction reflected in theMerger Plan based on valuation work performed, the advisory services of MorganStanley and negotiations with Terra under market conditions. As part of its financial advisory services to Telefonica, Morgan Stanley carriedout various analyses of the valuation of the companies in relation to thepreparation of its fairness opinion. The analyses, summarized below, were basedon closing prices for the ordinary shares of Telefonica and Terra as of February21, 2005, adjusted to reflect the following dividend distributions announced byeach of the two companies: i. Telefonica's share price: adjusted for a total of euro0.80 per share in dividends announced by Telefonica (which will not be payable to Terra's current shareholders in respect of the Telefonica shares they will receive following the merger, pursuant to the Merger Plan) as follows: (a) euro 0.23 per share cash dividend payable to Telefonica's current shareholders on May 13, 2005; on account of profits for the year ended December 31, 2004; and (b) the distribution of one Telefonica share held in treasury stock for every 25 Telefonica shares held by current Telefonica shareholders with a charge to the share premium reserve following the annual general shareholders' meeting to be held on May 25, 2005 (estimated at euro0.57 per share at Telefonica's closing share price as of February 21, 2005). ii. Terra's share price: adjusted for the extraordinary cash dividend of euro 0.60 per share announced by Terra's board on February 23, 2005, which will be distributed to Terra's current shareholders prior to inscription of the merger in the Commercial Registry. Trading Range Analysis Morgan Stanley reviewed the range of closing prices of Telefonica and Terraordinary shares for various periods ended February 21, 2005. Morgan Stanleyobserved the following: Period ended February 21, 2005 Telefonica Terra Last Three Months euro12.18 - euro13.76 euro2.20 - euro2.70 Last Six Months euro10.66 - euro13.76 euro2.17 - euro2.70 Last Twelve Months euro10.40 - euro13.76 euro2.17 - euro2.70 Morgan Stanley calculated that the exchange ratio of 2 Telefonica ordinaryshares for every 9 Terra ordinary shares pursuant to the Merger Plan representeda 15% premium on the unaffected share price of Terra ordinary shares as ofFebruary 11, 2005, and a 14% premium on the average price of Terra ordinaryshares for the 30 trading days prior to February 21, 2005. Comparable Companies Analysis Morgan Stanley compared certain financial information of Telefonica and Terrawith publicly available consensus financial projections in analysts' reports forother companies that shared similar business characteristics to Telefonica andTerra, respectively. The companies used in this comparison were as follows: 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: 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 merger with T-Online) For the purposes of this analysis, Morgan Stanley analyzed the ratio ofenterprise value (defined as market capitalization plus total debt less cash andcash equivalents, plus other adjustments) to estimated calendar year 2005earnings before interest, taxes, depreciation and amortization for Telefonicaand to estimated calendar year 2006 earnings before interest, taxes,depreciation and amortization for Terra. Morgan Stanley applied this multiple toTelefonica's 2005 and Terra's 2006 earnings before interest, taxes, depreciationand amortization, utilizing as information sources for Telefonica, publiclyavailable consensus financial projections analysts' reports, and for Terra,financial projections prepared by the management of Terra. Based on Telefonica's and Terra's current number of outstanding ordinary sharesand options, Morgan Stanley estimated the implied value per Telefonica and Terraordinary share, respectively, as of February 21, 2005, as follows: Comparable Companies' Relevant data Statistic Multiples Implied Value Per Share Financial data (EBITDA) Telefonica Aggregate Value to Estimated 2005 euro14,301 million 5.6x - 6.6x euro10.89 - euro13.77Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) Terra Aggregate Value to Estimated 2006 euro60 million 12.6x euro2.67Earnings Before Interest, Taxes, Depreciationand Amortization (EBITDA) None of the companies utilized in the comparable companies analysis areidentical to Telefonica or Terra. In evaluating comparable companies, MorganStanley made judgments and assumptions with regard to industry performance,general business, economic, market and financial conditions and other matters,many of which are beyond the control of Telefonica or Terra, such as the impactof competition on the businesses of Telefonica or Terra and the industrygenerally, industry growth and the absence of any adverse material change in thefinancial condition and prospects of Telefonica or Terra or the industry or inthe financial markets in general. Mathematical analysis (such as determining theaverage or median) is not in itself a meaningful method of using comparablecompany data. Discounted Cash Flow Analysis Morgan Stanley calculated the range of equity values per ordinary share forTelefonica and Terra based on a discounted cash flow analysis. With respect toTelefonica, Morgan Stanley relied on publicly available consensus financialprojections in analysts' reports for calendar years 2005 through 2010 andextrapolations from these projections for calendar years 2011 through 2014. Inarriving at a range of equity values per share of Telefonica ordinary shares,Morgan Stanley calculated the terminal value by applying a range of perpetualgrowth rates ranging from 1.0% to 1.5%. The unlevered free cash flows forcalendar year 2005 through 2014 and the terminal value were then discounted topresent values using a range of discount rates (weighted average cost ofcapital) of 8.0% to 9.0%. With respect to Terra, Morgan Stanley relied onTerra's financial projections provided by the management of Telefonica (which inturn had received them from Terra) for calendar years 2005 through 2008 andextrapolations from such projections for calendar years 2009 through 2014. With respect to those financial projections and other information and datarelating to Terra, including information as to Terra's tax situation, MorganStanley was advised by the Telefonica management that these projections andother information and data were prepared on bases of best current estimates andjudgments of the management of Telefonica as to the future financial performanceof Terra and of its tax situation. In arriving at a range of equity values pershare of Terra ordinary shares, Morgan Stanley calculated the terminal value byapplying a range of perpetual growth rates from 3.0% to 4.0%. 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 11.5% to 12.5%.The unlevered free cash flows included the benefits for Telefonica resultingfrom the business or future tax or other savings of Terra, as well as paymentsto be received by Terra under its strategic alliance agreement signed withTelefonica. The following table summarizes the results of Morgan Stanley's analysis: Implied Equity Implied Equity Value Key Assumptions Value (millions) Per Share (euro) Telefonica: 1.0% - 1.5% perpetual euro69,928-euro88,215 euro14.11-euro17.80growth rate, 8.0% - 9.0% discount rate Terra: 3.0% - 4.0% perpetual growth euro1,448-euro1,522 euro2.55 - euro2.68rate, 11.5% - 12.5% discount rate Equity Research Analysts' Price Targets Morgan Stanley reviewed and analyzed the public market trading price targets forTelefonica and Terra ordinary shares prepared and published by equity researchanalysts. These price targets reflect each analyst's estimate of the futurepublic market trading price of Telefonica and Terra ordinary shares. The rangeof equity analyst price targets reviewed for Telefonica and Terra were euro13.70 - euro15.70 and euro2.30 - euro2.65, respectively. The public market trading price targets published by equity research analysts donot necessarily reflect current market trading prices for Telefonica or Terraordinary shares and these estimates are subject to uncertainties, including thefuture financial performance of Telefonica and Terra and future financial marketconditions. Precedent Transactions Analysis Morgan Stanley reviewed Deutsche Telekom's minority buy-out tender offerfor the 26% free float of T-Online it did not own and the follow-on merger between Deutsche Telekom and T-Online announced onOctober 9, 2004. For the purposes of this analysis, Morgan Stanley analyzed the ratio ofenterprise value, defined as market capitalization plus total debt less cash andcash equivalents plus other adjustments, to estimated calendar year 2005earnings before interest, taxes, depreciation and amortization and applied thismultiple to Terra's 2005 earnings before interest, taxes, depreciation andamortization, included in the financial forecasts prepared by the management ofTerra. Based on Terra's current number of outstanding ordinary shares andoptions, Morgan Stanley estimated the implied value per Terra ordinary share asof February 21, 2005 as follows: Multiple applied Implied Financial based on precedent Value Per Financial data Statistic transaction Share Enterprise Value of Terra to Estimated euro52million 17.7x euro2.962005 Earnings Before Interest, Taxes, Depreciation and Amortization None of the companies or transactions utilized in the precedent transactionanalyses were identical to Terra or the merger. In evaluating the precedenttransaction, Morgan Stanley made judgments and assumptions with regards togeneral business, market and financial conditions and other matters, many ofwhich are beyond the control of Terra, such as the impact of competition on thebusiness of Terra or the industry generally, industry growth and the absence ofany adverse material change in the financial condition of Terra or the industryor in the financial markets in general, which could affect the public tradingvalue of the company or enterprise value of the transactions to which they arebeing compared. Exchange Ratio Analysis Morgan Stanley reviewed the ratios of the closing prices of Terra ordinaryshares divided by the corresponding closing prices of Telefonica ordinary sharesover various periods ended February 21, 2005. Morgan Stanley examined thepremiums represented by from the merger exchange ratio of 0.2222, as set forthin the Merger Plan, using the benchmarks mentioned below and found them to be asfollows: Telefonica Terra Implied exchange ratio Implied (euro/share) (euro/share) premium1last 90-day euro12.18 - euro2.20 euro2.20-euro2.70 0.181 - 0.196 23% - 13%average last six-month euro10.66 - euro13.76 euro2.17-euro2.70 0.196 - 0.204 9% - 13%average last twelve-month euro10.40 - euro13.76 euro2.17-euro2.70 0.196 - 0.209 6% - 13%average 1Implied premium defined as announced exchange ratio of 0.2222 divided byimplied exchange ratio for each average valuation Appendix II Terra engaged Citigroup Global Markets Limited (hereinafter Citigroup) andLehman Brothers Europe Limited (hereinafter Lehman Brothers) to providefinancial advisory services in connection with the Transaction and to assistTerra with the valuation process of Terra and Telefonica and Terra'sdetermination and justification of the proposed exchange ratio for the merger.On February 23, 2005 both entities rendered a fairness opinion to the Board ofDirectors of Terra in relation to the Transaction in which they concluded that,based upon and subject to the considerations set forth in their reports, themerger exchange ratio and the extraordinary dividend of euro0.60 per share tobe distributed by Terra to its shareholders pursuant to the Merger Plan werefair from a financial point of view for the shareholders of Terra other thanTelefonica. Terra determined the financial terms of the Transaction reflected in the MergerPlan based on valuation work performed, the advisory services of both firm andadvisors and negotiations with Telefonica under market conditions. As part of their financial advisory services to Terra, Citigroup and LehmanBrothers carried out various analyses of the valuation of Companies in relationto the preparation of their respective fairness opinions. A summary of theanalysis carried out by each of the aforementioned advisors is set out below: 1 Citigroup A summary of the principal financial analyses performed by Citigroup inconnection with the preparation of its fairness opinion is set out below. Forthese purposes, Citigroup considered, inter alia, the proposed dividend of €0.23 per share to be distributed by Telefonica with a charge to 2004 andthe distribution proposed by Telefonica of 1 Telefonica share for every 25Telefonica shares, in which holders of Terra shares would not benefit, as wellas the proposed dividend of euro0.60 per Terra share, which would be paid toall holders of Terra shares. Historical Share Price Performance Citigroup reviewed the relationship between movements in prices of Terraordinary shares and the implied offer price for the merger for the period fromJuly 25, 2003, the date on which Telefonica officially announced to the CNMV thenumber of Terra ordinary shares it had acquired in the tender offer, throughFebruary 11, 2005, the last trading day before Telefonica publicly announced itsintention to make an offer for a merger transaction with Terra. The impliedoffer price for the merger was calculated by multiplying the adjusted Telefonicashare price by the exchange ratio of 2/9 and then adding euro0.60 for theeffect of the anticipated dividend on Terra ordinary shares to be paid beforeconsummation of the merger. The adjusted Telefonica share price was arrived atby subtracting the anticipated cash dividend of euro0.23 from the Telefonicaunadjusted share price and then adjusting the result for the anticipateddividend in shares on Telefonica ordinary shares of one share for every 25shares. Terra shareholders will not participate in these cash and stockdividends. Citigroup also adjusted the Terra share price for the euro2.00 cashdividend per Terra ordinary share paid in July 2004 in the period prior to thepayment of such dividend. In addition, Citigroup compared the implied offer price with the trading priceof a Terra ordinary share on February 11, 2005 (the last trading day prior tothe public announcement of Telefonica's intention to make an offer) and the one-, three- and six-month averages trading prices in theperiods prior and up to February 21, 2005, in the case of Telefonica, and up toFebruary 11, 2005, in the case of Terra. The following table sets forth theresults of this analysis: Terra Ordinary Share Price Implied Offer Price (& Premium (euro) euro;)February 11, 2005 3.19 3.58 12%Last Month Average 3.11 3.56 14%Last 3-Month 2.96 3.49 18%AverageLast 6-Month 2.90 3.35 16%Average Precedent Transactions Analysis Considering that Telefonica currently controls Terra, Citigroup compared thepremium that the implied offer price for the merger represented over the priceon the last trading day before announcement and over the three- and six-month trailing averages with the premia paid similar last trading daysand for similar trailing periods represented by: • the cash consideration for four recent de-listing tender offers by Spanish companies; • the consideration in three recent mergers involving significant shareholders (owning less than half of the equity) of Spanish companies acquiring the remainder of the equity of those companies; and the consideration for two recent offers by controlling shareholders (owning overhalf of the equity) of European internet service providers to acquire theremainder of the equity of those companies. The precedent transactions considered by Citigroup were the following: Spanish De-Listing Offers Date Announced Company April 22, 2002 Hidroelectrica del Cantabrico December 9, 2003 Aceralia Corporacion Siderurgica SA May 31, 2004 Centros Comerciales Carrefour SA June 4, 2004 Cementos Molins SA Mergers with Significant Spanish Shareholder Date Announced Acquiror Target April 16, 2002 FCC Portland Valderrivas July 1, 2003 ACS Dragados Group August 1, 2003 Metrovacesa Bami Offers by Controlling Shareholders of European Internet companies Date Announced Acquiror TargetFebruary 23, 2004 France Telecom WanadooOctober 9, 2004 Deutsche Telekom T-Online Citigroup relied on publicly available for financial information for theprecedent transactions and the companies involved therein. The following tablesummarizes the median premia (discount) offered in these transactions over theprice on the last trading day before announcement and the three- and six-month trailing averages and, in the far right column, sets forth forcomparative purposes the same information for the implied offer price in theproposed merger between Terra and Telefonica: Period Median Spanish De Median Spanish Merger Median European ISP Implied Offer Price -Listing Consideration Premia Premia Premium For Proposed Offer Premia Merger (Discount)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 observed that none of the precedent transactions were identical to theproposed merger of Terra and Telefonica. Terra Valuation Discounted Cash Flow Analysis Citigroup's primary methodology for reviewing the value of Terra was a sum-of-the-parts discounted cash flow analysis for each ofTerra's individual operating assets and certain non-operating assets.Citigroup applied country-specific discount rates based on weightedaverage cost of capital assumptions to calculate the net present value of Terramanagement's forecast free cash flows from its operating assets, the benefits offuture tax savings relating to net operating losses and payments to be receivedby Terra under its strategic alliance agreement with Telefonica. Citigroupapplied greater discount rates, however, to calculate the net present value of apotential additional tax credit resulting from the August 2, 2004 sale by Terraof Lycos Inc. as Terra's ability to realize value from this contingent asset isspeculative and difficult to predict. Citigroup then adjusted the value of Terrato reflect Terra's net cash (including amounts due from Telefonica under taxsharing arrangements) and other non-operating assets (includinginvestments in unconsolidated entities and other non-wholly ownedaffiliates and anticipated proceeds from disposals). The result of this sum-of-the-parts discounted cash flow analysis was animplied value per Terra ordinary share of euro2.90 to euro3.71. Comparable Companies Analysis Using publicly available information, Citigroup reviewed the relative shareprice performance from July 2003 to February 2005 of Terra and the followingfive listed European internet service providers, as well as a market-weighted index comprised of these companies: • freenet.de • Iliad • Telecom Italia Media • Tiscali • United Internet Citigroup also compared the listed companies' multiples of firm value (equal toequity value plus straight debt, minority interests, straight preferred stock,all out-of-the-money convertibles, less investments inunconsolidated affiliates and cash) to forecasted revenues, gross profit andprojected EBITDA for 2005 - 2007 with such multiples for Terra.Citigroup then calculated a range of illustrative valuations for Terra'soperating assets by applying variances of plus or minus 10% from the medians ofsuch multiples for the comparable companies to Terra's management's forecastsand then adding Terra's net cash and other non-operating assets valuedin a manner consistent with the methodology employed in the analysis describedabove under the section "Discounted Cash Flow Analysis". The result of thiscomparable companies analysis was an implied value per Terra ordinary share of €2.73 to euro3.77. Citigroup observed that none of the selected companies were identical to Terra.In particular, Citigroup noted that Terra's lower expected profitability for2005-2007 would suggest a valuation of Terra toward the lower end of thevaluation range. Research Analysts' Target Prices Citigroup reviewed research analysts' target prices for Terra ordinary sharespublished between July 1, 2004 (after adjusting for the euro2.00 cash dividendper Terra ordinary share paid in July 2004) and February 15, 2005. The range ofthese target prices (excluding the highest and lowest values) was from euro2.80 to euro3.17. Telefonica Valuation Citigroup was not provided with any non-publicly available business orfinancial information, including financial projections, for Telefonica andCitigroup had no access to Telefonica's management. This limited the valuationanalyses with respect to Telefonica that were available to Citigroup. Citigroup reviewed the value of Telefonica using a sum-of-the-parts analysis that used various valuation methodologies forTelefonica's primary operating assets, including trading comparables and marketvalue, and then adjusted for overhead costs, non-operating assets andliabilities and minority interests. For Telefonica's principal operatingassets-Telefonica Moviles, the fixed-line Spanish telecommunicationsbusiness and Telefonica International-which collectively represent the majorityof Telefonica's firm value, Citigroup's primary valuation methodology was basedon a comparable companies analysis. Citigroup compared Telefonica Moviles toTelecom Italia Mobile and Vodafone and its market value; the Spanish fixed-line business was compared to British Telecom, and TelefonicaInternational to Telmex, Telesp, Brasil Telecom and Tele Norte Leste. The resultof this analysis was an implied value in the range of euro13.36 to euro16.39per Telefonica share, as compared to a market price of euro14.19 perTelefonica share as of February 21, 2005. Citigroup also reviewed research analysts' target prices for Telefonica ordinaryshares published between June 18, 2004 and February 11, 2005. The range of thesetarget prices (excluding the three highest and the three lowest values) was fromeuro13.50 to euro16.50. 2 Lehman Brothers A summary of the financial analysis utilized by Lehman Brothers in relation withRelated Shares:
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