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Fitch Changes Telefonica's Outlook to Positive

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Fitch Ratings has today changed Telefonica's and its subsidiary O2's Outlooks to Positive from Stable following yesterday's fourth quarter and FY07 earnings announcement. Telefonica's ratings are affirmed at Long term Issuer Default (IDR) 'BBB ' and Short term IDR 'F2'. O2's Long term IDR is also affirmed at 'BBB '. Telefonica Finance USA's preference shares are affirmed at 'BBB'.

"The Outlook change reflects Telefonica's solid de-leveraging over the past 18 months, with FYE07 net debt/EBITDA of 2.3x, compared to over 3x immediately following the O2 acquisition in 2006," said Stuart Reid, a Director in Fitch's European TMT team. "Telefonica is among the few incumbent telecom operators in Europe that is now reducing this metric, and doing so, largely as a result of strong operational performance. Continued improvement in the trend is likely to place increasing upward pressure on the ratings."

Fitch considers Telefonica to have one of the stronger business profiles and (pre-distribution) free cash flows among the European incumbent/large telecom operators. Were leverage to trend towards the lower end of the company's 2x-2.5x target metric, it would be more in line with that exhibited by France Telecom and Vodafone.

While Telefonica's current performance guidance for 2008 suggests this kind of leverage could be achieved by YE08, Fitch has taken a somewhat cautious stance towards its rating given the company's historical disposition towards M&A and acceptance of a higher leverage metric when presented with a compelling acquisition opportunity. Fitch recognises the strategic value of acquisitions such as O2 and Telecom Columbia (2006), which have improved the business profile and enhanced the cash flow potential of the overall group. Incremental M&A, however, considerably lifted leverage outside stated financial policies over this timeframe. De-leveraging has since been impressive though, which although helped by some asset sales, has mainly been driven by the incremental cash flow of acquisitions and the growth of the company's broad mix of integrated, fixed and mobile operations.

Key triggers for an upgrade of the rating include de-leveraging to a level that is expected to be sustained towards the low 2x range. This would need to be achieved by Telefonica's ongoing underlying operating performance rather than opportunistic assets sales, and be accompanied by continued strength in free cash flow and business conditions. In the near term Fitch expects free cash flow to continue to be underpinned by Telefonica's mature domestic operations, while the potential of its international businesses (in particular Latin America) is expected to drive OIBDA/EBITDA growth. It will be important for the company to sustain the strong performances currently being achieved in each of its key businesses - Spain, Telefonica Europe and Latin America. Fitch takes particular assurance from Telefonica's strong market positions in both fixed and mobile operations in Spain, markets that are not as intensely competitive as the UK, for instance. Domestic competition and regulation are therefore key areas to watch.

In terms of M&A, the company has emphasised a commitment to its existing footprint and noted joint venture partner, Portugal Telecom's stake in leading Brazilian mobile operator, VIVO, as its most obvious target. Subject to valuation and how such a transaction might be financed, Fitch considers it possible for Telefonica to reach leverage in the low 2x range, while noting that M&A remains the most likely inhibitor to an upgrade at this stage. While the company's exposure to Latin America adds a degree of currency and geopolitical risk, the company's broadly diversified portfolio in the region, strong market positions and the increasing economic maturity of many of the countries in which it is present, have reduced this risk.

Liquidity is strong with Telefonica facing negligible debt maturities (EUR300m) in 2008 and EUR4.4bn in 2009. Refinancing activity undertaken in the first half of 2007 means that the company has no refinancing needs through to end-2009, given its access to EUR9.8bn in undrawn bank facilities (EUR5.2bn maturing 2009 and beyond) and EUR8.9bn in cash and financial investments (at YE07). Short-term funding remains readily available, with Telefonica reporting no problems in continuing to roll over EUR2.0bn in commercial paper at funding spreads close to zero.

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