Aol's Competitor? Hmm...

Juan Villalonga was not happy. The 47-year-old chairman of Spain's high-flying Internet service provider, Terra Networks, had guided his company through a wildly successful IPO in 1999 and an acquisition campaign in Latin America. But, he confided to Thomas Middelhoff one day last April, his plan for cracking the all-important U.S. Internet market by buying U.S. portal company Lycos was stalled. Middelhoff, the CEO of German media giant Bertelsmann, was visiting Villalonga in Miami to discuss other business. But he quickly picked up the phone and dialed Lycos CEO Robert Davis--a colleague, since Bertelsmann owns a chunk of Lycos Europe--and a three-way meeting ensued, restarting the merger talks. On May 16 it became official: Terra Networks will buy Lycos for $12.5 billion in stock. Bertelsmann will make its vast trove of books, music and film available to the new company on preferred terms, and has also committed to buy $1 billion worth of advertising and other services over the next five years. "From today, AOL has a competitor," declared a beaming Villalonga as he unveiled the newly created Terra Lycos at a New York press conference.

Well, maybe from tomorrow. At the moment, Terra is a regional player, strong in Spain and Latin America but not elsewhere, while in the United States, Lycos lags the likes of Yahoo! and AOL by a wide margin. Yet Terra Lycos could be a contender, many analysts reckon. Scale and market share are the name of the game in the Net wars, and the idea of signing up viewers on several continents at once has great appeal--as AOL and Yahoo, both busily building their operations outside the United States, can attest. A spinoff of Spain's ambitious telecom operator Telefonica (also chaired by Villalonga, and also a major presence in Latin America), Terra Network is the first big European Internet company to reverse the prevailing order of things and go shopping on AOL's home turf. "Now the Internet is truly global," says James MacAonghus, Internet analyst with Jupiter Communications in London. "Before it was only global in theory."

Yet however grand the vision, this is also a deal born of necessity. Terra has 2 million customers, but its pay-for-Web-access business model is losing steam as U.S.-style unlimited service comes to its markets. So besides a position in America, it needs to offer more cool stuff for more people to look at longer so it can charge higher rates to advertisers. Lycos is one of the few high-content portals around, but with Yahoo and AOL attracting so many more eyeballs, it needs access to Terra's customers. Bertelsmann, the world's No. 3 media company, needs to secure its future distribution channels in a world where Time Warner has stolen a march on everyone by selling out to AOL. Middelhoff is especially enthusiastic about pumping his content out over mobile phones via a separate venture with Telefonica. "For Bertelsmann it is perfect," he says.

And maybe something of a relief as well. All three CEOs have recent disappointments to forget. Villalonga was stung earlier this month when Telefonica tried to buy Dutch telecom company KPN--the Spanish government (which retains a golden share in the former state-owned monopoly) blocked the deal. Lycos had been in play for more than a year, ever since a key shareholder vetoed Davis's plan to merge with USA Networks, Barry Diller's media company. "This is a radically different scenario," says Davis. "I have zero fear this will not go through." As for Middelhoff, he was the odd man out when AOL, his erstwhile partner in Europe, bought his rival, Time Warner. He has since resigned from AOL's board but, unlike Villalonga, carefully downplays talk of a rivalry. "It is not a competition with AOL. We are only interested in getting the maximum traffic for our e-commerce business."

Before that can happen, of course, the deal has to close. That's likely, but--given the wild swings in the share prices of the two companies--not done until it's done. "These are two very volatile pieces of paper," warns Schroeder Salomon Smith Barney analyst Gerard van Hamel Platerink. Lycos shares doubled in the three weeks before the deal, dropped 21 percent the day after it was announced, then edged back up slightly. Terra was down 17.4 percent by the end of the week. But don't read too much into the share price just yet. Even Merrill Lynch Internet analyst Peter Bradshaw, who downgraded Terra for paying an 80 percent premium on Lycos shares, notes that "it's not a bad deal." The main question, he says, is whether the new company can execute its plans. Bradshaw is going to pay particular attention to how Terra Lycos spends the $3 billion in cash it means to raise with Telefonica's help--the biggest cash hoard in the Internet world.

As with many mergers, the toughest challenges could be cultural and personal. Villalonga, known for his healthy self-esteem and habit of getting his way, parted company with Terra's president earlier this year over competing visions for the company. As chairman of Terra Lycos, he can't afford a repeat--he needs the savvy, battle-hardened management at the company he's buying. Davis, a tough-minded entrepreneur with an ego of his own, signed a five-year contract and says his commitment is permanent plus one day. "This is not a job, it's a life, it's my passion," he says.

Lycos employees applauded wildly for Davis as he described the deal at the New York press conference. After all, he secured them a safe harbor and a whopping premium for the company shares they own. "We'd walk through fire for him," one explained afterward. In another part of the program, the execs were asked about the headquarters of the new company--whether it would be in Massachusetts, where Lycos is based, or in Miami, where Villalonga has a home. Villalonga interrupted Davis to answer: "The chairman of Telefonica and the chairman of Terra Lycos has many homes. We will be where the business is." Sound logic, perhaps. But there was no applause.

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