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Letter to shareholders

Dear shareholders,

It is for me a pleasure to share with you all an account of Telefónica’s performance and results in 2014 and review the main milestones we have reached in our effort to become a Leading Digital Telco in an industry that opens opportunities for us all.

In my speech a year ago, I told you that 2014 would be a key year to transform Telefónica into a company that grows more and a company that is more efficient and technologically fit. How satisfying to look back and see that we have made significant progress in that direction.

In 2014 we reached the culmination of a period of intense transformation which began in 2012. Those two years were essential, because they enabled us to lay solid foundations for accelerating our growth.

Telefónica is already a very different company indeed, a company that grows more. In 2014 we significantly accelerated our revenues’ organic growth to 2.6%, more than three times the increase registered in 2013. Our solid growth in Telefónica Hispanoamérica, the stabilisation of our business in Spain, our strong boost from digital services (which rose nearly 30%), and the initiatives we have rolled out to monetise data traffic growth were key factors in this achievement.

The performance of our revenue figures reflects strong traction in the take-up of high-value services: Pay-TV accesses have grown nearly 50%, and contract accesses have risen 11% for mobiles and 39% for smartphones. This has allowed a turnaround in the trend of average revenue per access, which grew for the first time in recent years, while the number of accesses also grew to over 340 million.

Our focus on high-value customers is backed by the major technological transformation Telefónica has undergone in recent years, which was driven by heavy investment effort.

For instance, in 2014 we doubled the reach of our fibre network to 15 million premises passed and we reached a 4G coverage of 60% in Europe, while in Latin America this service is already available in ten countries. In parallel, we advanced significantly toward transforming our systems.

Therefore, we boosted investments to almost 9.5 billion euros, including the sum allocated to spectrum. In other words, we invested around 16% of our revenue, the highest amount recorded in our recent history.

Also in 2014 we implemented a new operating model to make us more agile. The new model is already enabling us to achieve improved efficiency, thanks to its focus on simplification. The idea is to transform ourselves in order to gain process agility and improve our response capacity to the level our customers demand, while reinforcing the sustainability of our business.

The efforts we made in 2014 are evident and have enabled us to slightly grow in organic OIBDA once again, reflecting our revenue growth and the benefits we are obtaining from our new efficiency measures. Thanks to our efforts, in 2014 we reached an OIBDA margin of 31%.

Stronger position in key markets

In 2014 we also conducted a thorough transformation of our asset portfolio. Our aim was a clear one: to gain strength in strategic markets that contribute to Group growth.

First, we led intra-market consolidation in Europe, and in 2015 we did it again in Brazil, with acquisitions that create value and have significant synergy potential. Our acquisitions of E-Plus in Germany and GVT in Brazil will enable us to grow more in the two biggest markets in Europe and Latin America. In addition, with our recently concluded purchase of DTS (Digital+) in Spain, we have taken a major step toward strengthening our position as a worldwide video company.

Brazil has thus become our primary market in terms of both access numbers (over 100 million customers) and revenue volume.

Second, we decided to withdraw from other markets that due to either their size or our position there are less strategic fits in the medium and long term. Hence, we have reached an agreement to sell off Telefónica’s business in the United Kingdom, which will improve our financial flexibility.

In just over two years, we have managed to strengthen our balance sheet quite significantly. We reduced our debt by more than 13 billion euros by the end of 2014, positioning ourselves as the company that lowered its debt more than any other in our industry during that period. The amount of debt we reduced would be considerably higher if we factored in the sale of O2 United Kingdom.

These achievements have been possible thanks to the excellent work of all the professionals here at Telefónica, whom I would like to thank for their dedication and commitment.

Allow me to close this brief summary by highlighting that, considering the speed of changes around us, we will continue to drive our Company’s transformation forward. Have no doubt that this year we will consolidate the acceleration of our growth.

And we are going to do that in a context of world economic recovery.

In Spain, 2014 was a turning point. Right now Spain is registering one of the highest GDP growth and employment rates in Europe. This trend is expected to continue over the next few years, with an economic growth rate of close to 3% for 2015 and 2016. Germany, another of our key markets, will be growing at around 2% in 2015 thanks to the favourable growth of its internal demand, particularly private consumer spending.

In the case of Latin America, the outlooks for 2015 for the region as a whole are highly positive. In Brazil in particular, the economic and social achievements accomplished in the past together with the country’s huge size and recent economic policy changes will drive medium-term economic growth.

Attractive shareholder remuneration

Our strategy shows in the upward trend in Telefónica’s total shareholder return, 7% in 2014.

Our share price has climbed 9.3%(1) so far in 2015, making the increase close to 28% since early 2013. The rise in share price in conjunction with the dividends distributed over the last period add up to a total shareholder return of more than 40%.

As part of the shareholder dividend policy announced in February of this year, the Company intends to propose a dividend of 0.75 euros per share for 2015; 0.35 euros will be distributed in the fourth quarter of 2015 as a scrip dividend, further to the proposal submitted to this General Shareholders’ Meeting, while the remaining 0.40 euros will be paid in cash in the second quarter of 2016.

The Board has also submitted a proposal to amortise a number of treasury shares in 2015, adding up to 1.5% of the share capital.

In addition, in 2016 it is the Company’s intention to amortise treasury stock adding up to a total of 1.5% of the share capital and distribute a dividend of 0.75 euros per share in cash, in both cases subject to the closing of the proposed sale of O2 United Kingdom.

In due time the Company will propose the appropriate shareholders’ resolutions.

At the present share price (12.88 euros on 29/5/15), the remuneration announced for 2015 constitutes a 5.8% yield, the highest return of any of the major Telco players.

In short, for yet another year Telefónica is honouring its firm commitment to remunerate its shareholders, a clear priority for our Company.

A great opportunity ahead

The digital ecosystem has been undergoing a spectacular transformation over the last few years. This is the Digital Revolution, the greatest revolution in the history of mankind, which opens new opportunities to everybody and every industry.

In an increasingly global world, the digitisation of the economy is a key factor to gain competitiveness and spur growth, thus influencing the level of welfare and development of countries. And at Telefónica we are extremely lucky to be in an industry that offers people new opportunities and has the power to transform societies and make them better.

We stand at the gates of a new era of innovation and change. This is the era of the Industrial Internet, which arises from the convergence of the industrial system with the power of advanced computing and new levels of connectivity. In fact, the Industrial Internet is expected to add an additional 15 trillion dollars to the global economy over the next 20 years.

Machines connected to each other are already a reality in the digital ecosystem, and their future potential is huge. We are already witnessing the proliferation of wearables, connected cars, connected homes and smart cities which, economic considerations apart, are making people’s lives easier.

This increase in connectivity is generating large amounts of information. Managing and using all that information is what we call “Big Data”, and Big Data will be tremendously useful for governments and companies, since they will have access to the key information they need to accomplish their role in society.

And networks lie at the core of this new economy. Networks allow greater integration of all the elements that support the production, distribution and consumption of the new digital processes and assets. Networks have become the primary infrastructure for fostering economic growth. Therefore, the Telco industry is a key player for the future.

In this context, competition in the digital ecosystem has changed in response to the new environment. Accordingly, it is vital to revise regulations to address the reality of the new digital economy and to consider the entire Internet value chain. It is a matter of ensuring that the rules of the game apply equally to all the agents in the ecosystem, to guarantee a level playing field under the “same service, same rules” principle, where there is no discrimination. This will allow citizens to enjoy better protection of their rights and an open, transparent, safer Internet experience for us all.

Commitment to society

To conclude, I would like to remind you that at Telefónica we have always demonstrated our firm commitment to societies where we are present.

To begin with, we support the new generations of young people, and you can see this commitment in the many programmes and activities we run to help young people reach their career goals. To help stimulate entrepreneurship and help make their ideas a reality.

In this sense, Telefónica Open Future is an open, global innovation programme that comprises all our entrepreneurship, innovation, investment and transformation initiatives to support talent by covering all stages of entrepreneurial endeavour.

The programme is being run in 17 countries. Through its various initiatives aimed at investing directly in the various stages of new tech companies, Telefónica Open Future has committed, as of today, more than 700 million euros and secured nearly 7,000 jobs. Altogether, the programme combines the work of Telefónica R&D+i with the objective of optimising the Company’s future capital investments and making the Company a key player in high-growth areas of our industry.

In parallel, to stay at the forefront of technology and innovation, in 2014 the Company boosted its investment in technological innovation by 13.5% to 6,974 million euros, positioning Telefónica as the top European telco operator and third worldwide in terms of investment in R&D.

Furthermore, our commitment to society is also strongly reflected in various initiatives involving digital education, a key lever for the development of individuals and societies as a whole.

Telefónica is already a leading player in digital education, providing education for youth and teachers as well as open virtual learning environments. And we are going to do even more in future by encouraging digital learning throughout every stage of education.

In addition, we are conducting other initiatives in cultural promotion and support for youth through Fundación Telefónica.

Lastly, Telefónica promotes corporate sustainability by ensuring that our innovation processes impact positively on society’s development, accessibility and environmental protection, while at the same time creating sustainable products and services for our customers.

Dear shareholders, as you have seen, Telefónica is not just a leading company in this new digital world. Telefónica has a solid commitment to society. We are convinced that technology should be open to all individuals, companies and governments so that they can BE MORE.

On my own behalf and on behalf of the Board of Directors, I want to thank you again this year for your support and trust. Having you behind us is certainly the best incentive to keep us building the Leading Digital Telco in our industry.

Thank you,

César Alierta
Executive Chairman