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Terra Firma?

Lycos's deal with Terra Networks is its second bid to become an Internet powerhouse. Could it unravel?

1Sep

Next month, shareholders of Lycos Inc. will decide if they want to join forces with the leading Spanish Internet service provider, Terra Networks SA. Terra who, you ask? Terra is the offspring of Telefonica SA, Spain's privatized phone utility, and its stock was trading around $150 last winter. U.S.-based Internet portals such as Lycos are increasingly looking abroad for growth, and here a Spanish player with an expanding presence in Latin America came to Lycos with a hefty offer. Now Lycos management, for the second time in two years, is enticing shareholders with a fascinating, but risky, deal. And if shareholders say no, it will send Lycos back to the drawing board to keep pace with its Internet peers.


It's been difficult for Lycos to keep up with the likes of America Online and Yahoo. It consistently ranks fourth in total U.S. Web traffic (after AOL, Microsoft's sites, and Yahoo). All the same, its announcement in May that it would be acquired by Terra Networks came out of left field. The offer--$97.55 worth of Terra's shares, based on its stock price at the time of $56--was a lush premium for Lycos, which was trading at about $60 at the time. For Terra, the deal represented the crowning achievement of an aggressive worldwide expansion program that included acquisitions in Mexico, Brazil, and Chile. For Lycos, whose merger with USA Networks fizzled amidst shareholder skepticism, the new deal was heralded as a bold move onto the international stage. "Overnight, in one fell swoop, this company has jumped from strong Internet competitor to a global powerhouse," claimed Lycos CEO Bob Davis at the time of the deal.


But the deal only served to confuse many investors. It was the world's first international portal acquisition, and the acquirer was a relative unknown. In addition, Terra's stock has slumped more than 20 points since the announcement, and analysts caution that the deal is not a certainty, especially if that trend continues. Ted Philip, Lycos's chief operating officer and CFO insists, of course, that he "sees nothing that keeps this deal from closing." Still, the investor reaction underscores risks associated with cross- border deals when a foreign acquirer is using an inflated stock price to make an acquisition.


"It's risky to the Lycos management from the standpoint that they're putting all their cards on the table and assuming this deal will go through, when the reality is that if Terra's price gets too weak, there won't be a real takeover premium for shareholders," notes Frederick Moran, head of Internet research at Jefferies & Co., in New York. As European Internet shares falter like their U.S. counterparts, shareholders may have to choose between the longer-term strategic sense of the deal and the desire for a significant premium.



Visionary, or Deal-hungry?

In part because of the risk, Terra has been a generous suitor. As part of the deal, parent Telefonica agreed to underwrite a $2 billion rights offering for the new company, to be called Terra Lycos. And anticipating potential deflation in Terra shares, the deal included a collar that guaranteed the deal price as long as Terra's stock stayed within a 20 percent range for a 10-day period before the close of the merger, which is expected to be in October. If the price falls below the collar, Lycos holders would receive a maximum of 2.15 Terra shares per share; if the stock soars, Lycos shareholders would receive no less than 1.43 Terra shares.


But Lycos shares have not spiked to meet the premium as Terra's stock has fallen below the collar. In addition, in July Telefonica and Terra chairman Juan Villalonga was forced to resign, following allegations that he engaged in insider trading.


For Lycos, there is the additional overhang from its previous failure. In February 1999, Lycos agreed to merge with assets of CEO Barry Diller's USA Networks in a $6 billion deal that would have created a multimedia entity with a strong cash flow and after-depreciation profits. But the Internet world, more interested in stock valuation than cash flow, didn't know what to make of an Internet media hybrid, and shareholders rejected the deal.


What's different this time, of course, is the new religion in Internet circles about profitable business models that has emerged post- AOL­Time Warner. Lycos is financially strong for an Internet company. It has a positive cash flow of more than $50 million from operations for the first three quarters of its fiscal year, which ended July 31. For its third quarter, it reported revenues of $78.6 million, a 120 percent year-over-year increase and a 15 percent increase from its previous quarter. Lycos also delivered earnings per share of $1.05, although that reflects a one-time gain of $270 million from the initial public offering of Lycos Europe, of which it owns 43.8 percent.


In addition, Lycos has already recognized that international growth is where the action is for portals. Yahoo derived 15 percent of its revenue from foreign operations in its last quarter. Lycos, which has established beachheads outside Europe, including in Asia and Canada, has expanded internationally through joint ventures, says Philip, which means its foreign revenue amounts cannot be claimed.


Still, the question must be asked: Is Lycos trying to shape a multilingual global media concern, or is it simply deal hungry, afraid that it's being left in the dust by the likes of AOL and Yahoo?


"This is not a merger out of necessity," insists Philip. "It is a merger out of opportunity." Yet, while Lycos's success is a result of aggressive deal- making--it rapidly expanded through a series of well-timed acquisitions of such properties as Tripod, a personal Web page builder, and Hotbot, a Web search site--it has never been able to catch up with Yahoo. In fact, the gap, in terms of U.S. audience, is growing. In June, Yahoo had 48 million unique visitors to its Web sites, compared with 31 million for Lycos's properties.


Lycos has been growing, but maybe not fast enough. "In the media world, in the Internet media particularly, the world is becoming a very small place," says Lucas Graves, a senior analyst at Jupiter Communications Inc., in New York, who covers Latin American new media. "There is growing pressure for offline and online properties to unite, and for these unified media businesses to play on a global stage." Although there aren't compelling synergies between Lycos and Terra, says Graves, Lycos may fit into parent Telefonica's larger ambitions to expand its telecommunications and media empire. "There are still missing pieces of the puzzle, but with further acquisitions, they'll grow into this global telecommunications/Internet/media company," says Graves. "But they're growing into a second- tier global media company. They're still not in the same ballpark as AOL or Yahoo."



The Right Partner

One understands the compulsion to grow by merging, but the question remains whether Lycos picked an appropriate partner. Terra's income statement looks like many of the high-flying U.S. Internet companies of a year ago: rapid growth coupled with high customer acquisition costs and large losses. Terra's losses-- 165.9 million euros--amounted to almost twice its revenues for the first six months of 2000. However, its subscriber base, following rapid acquisitions in Latin America, doubled during the first half of the year, to 2.66 million customers. The losses, in part, reflect the considerable costs of entering six new countries this year. "Investors understand that in developing markets, you need to have those losses to get market share," says Philip.


Although it is far from certain, most observers are betting the deal will go through. The rights offering, to be guaranteed by Telefonica, will give the new company "a big cash pile of $3.2 billion," which would place Terra Lycos 23rd in the Fortune 500 in terms of cash strength, says Morten Andersen, a London- based Internet analyst for Deutsche Bank. The deal also "leaves Terra Lycos with presence in more countries [37] than anyone else," Andersen says. He gives the deal an 80 percent to 90 percent chance of going through. The risk? "Terra's stock price completely collapses. If shareholders don't vote it through, it would have to be from concern over the value of the Latin American business," says Andersen.


Should the worst happen, it would be another dramatic swing and miss for Lycos. Philip rejects the possibility of not connecting this time. "This is about two complementary companies with very little overlap that cover every area of the world," he says. And shareholders support it, he adds. But in the Internet world, as Philip learned last year, support can erode quickly.




George Donnelly (georgedonnelly@cfo.com) is a senior editor at
CFO.

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