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Rating Action:

MOODY'S DOWNGRADES TELEFONICA TO Baa1, OUTLOOK STABLE

22 Dec 2005
MOODY'S DOWNGRADES TELEFONICA TO Baa1, OUTLOOK STABLE

Madrid, December 22, 2005 -- Moody's Investors Service has today downgraded to Baa1 from A3 the senior unsecured rating of Telefónica S.A (Telefónica) and to Baa3 from Baa2 the company's subsidiary preferred stock rating. Simultaneously, the National Scale Ratings of Telefónica Finanzas Mexico, S.A. de C.V. Mexican peso Programa de Certificados Bursatiles have been confirmed at Aaa.mx. The rating downgrade reflects the increased financial risk derived from the proposed cash acquisition of O2 plc (O2). The Prime-2 short-term rating was affirmed as it was not affected by the rating review process.

The stable rating outlook reflects Moody's expectation that management will maintain a strong liquidity profile, despite the huge refinancing needs, and that the integration of O2 within Telefónica will be smooth. Moody's expects the company's management to strengthen its financial metrics over the medium term and achieve a maximum debt to Ebitda of 2.5 times and RCF-to-Debt ratio of 30%. However, Moody's cautions that, within its current rating category, Telefónica has limited room for deviating from the deleveraging strategy expected by Moody's. In addition, any difficulty experienced in the debt refinancing would also put pressure on the ratings.

These rating actions complete the rating review process initiated on 31 October 2005, when Telefónica announced its intention to acquire O2.

Moody's explains that the downgrades reflect Telefónica´s increased financial risk as a result of the cash offer to acquire O2. The offer is expected to be completed by the end of January 2006 and values O2 at approximately GBP17.7 billion (EUR26 billion). Although the transaction is subject to O2 shareholders' acceptance (current indications show an acceptance level of over 65%) and EU approval, Moody´s rating action is based on the assumption that the transaction will be successfully completed.

Even though the cash transaction has a severe upfront impact on Telefónica´s debt ratios, Moody's notes that the deal will also provide it with the benefits of the operating strength, quality of management and diversification inherent in O2. Moody's expects Telefónica to substantially increase its free cash flow generation over the next few years, which, together with the current shareholder remuneration strategy, will enable the group to reduce debt over the medium term and achieve adequate cash-flow-to-debt ratios for this new rating category. For example, RCF to debt is expected to reach a minimum level in the low twenties during 2006 and thereafter improve to reach about 30% in the medium term.

During 2005, Telefónica has significantly shifted its strategy to undertake an enhanced international expansion which provides the group with a larger scale and scope. Although this implies a significant use of its financial flexibility, Moody's believes that it also rebalances Telefónica's international exposure and positions the group to take advantage of growth opportunities in new markets. Indeed, Moody's points out that the acquisitions of Cesky Telecom, the offer for O2 and the investment and co-operation agreements signed with China Netcom, represent a substantial enlargement to Telefónica´s traditional Latin American international strategy.

Moody's cautions that this enhanced international strategy also poses a challenge to management's ability to integrate these companies and simultaneously successfully implement the strategy in the increasingly competitive Spanish and Latin American operations. In this regard, Telefónica has recently introduced management organizational changes with a view to accelerating the integration of the different businesses and to maximize the operational leverage obtained from the Group's scale, footprint and market leadership. For example, once the acquisition of O2 has been finalized, the company's CEO, Peter Erskine, will retain his position at a newly created European division which will also include Cesky Telecom and Telefónica Deutschland.

Moody's has also takes into consideration Telefónica's liquidity profile. Specifically, Moody´s notes that although the refinancing risk in 2006 is low with just over Euro 3 billion debt maturities, Telefónica faces substantial debt maturities of some Euro 11billion in 2007 and Euro 20 billion in 2008. To support its liquidity, the company recently signed a syndicated GBP 18 billion bridge bank facility (the syndication was more than twice oversubscribed with nearly GBP 40 billion raised from 40 banks). Maturities are extendable (term options) to 2, 2.5 and 3 years, which adds to the existing Euro 6 billion and Euro 3 billion syndicated committed and Euro 4 billion bi-laterals, cash balance of some Euro 2.5 billion and liquid investments. We expect substantial bond issues in the market in the near-term to refinance and extent the maturity profile. However, the existing bank facilities support the company's liquidity over the next 12 months without necessarily having to access the capital markets.

The ratings of Telefónica and its subsidiaries were downgraded as follows:

- Telefonica Finance USA LLC's EUR2.0 billion preference share issue: downgraded to Baa3.

- Telefonica Europe BV's A3 EUR8 billion MTN and all drawdowns under the programme as well term loan facilities: downgraded to Baa1.

- Telefónica S.A.´s EUR3 billion bank loan and senior unsecured bond ratings: downgraded to Baa1.

- Telefónica Emisiones S.A.U. EUR15 billion MTN and all drawdowns under the programme: downgraded to Baa1 for senior unsecured and Baa2 for subordinated debt issues.

- Telefónica Finanzas Mexico, S.A. de C.V. Nacional Scale Rating on its MXN12 billion (Mexican Peso) Programa de Certificados Bursatiles: confirmed at Aaa.mx

Headquartered in Madrid, Spain, Telefónica S.A. is the second-largest European telecommunications company by market capitalisation. In Spain, Telefónica has over 80 years' experience as a leading telecommunications operator, with over 16 million fixed lines, close to 5 million data and internet access lines and, as at September 2005, more than 19 million mobile customers.Telefónica has had a presence in Latin America for over 15 years, with cumulative investments in infrastructure and acquisitions of over EUR70 billion for the period from 1990 to 2004. Telefónica is a leading operator in Brazil, Argentina, Chile and Peru and has substantial operations in Colombia, Ecuador, El Salvador, Guatemala, Mexico, Nicaragua, Panama, Puerto Rico, Uruguay and Venezuela.

Madrid
Carlos Winzer
Senior Vice President
Corporate Finance Group
Moody's Investors Service Espana, S.A.
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

London
David G. Staples
Managing Director
Corporate Finance Group
Moody's Investors Service Ltd.
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

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