SAN FRANCISCO (05/17/2000) - Spanish Internet group Terra Networks SA agreed on Tuesday to a $12.5 billion stock acquisition of Internet search company Lycos Inc. (LCOS) , a deal that the new company's chairman described as a challenge to America Online Inc.'s dominance of the Web.

The new company, which would be called Terra Lycos Inc., would operate in 37 countries and have 60 million customers worldwide. The deal values Lycos stock at $97.55 a share - 80 percent more than Lycos' stock price on Friday and 34 percent higher than the company's closing price on Tuesday, when Lycos climbed 18 percent as word of the deal leaked out.

German media company Bertelsmann AG announced Tuesday that it would pay $1 billion during the next five years for advertising and placement with the combined company, making Bertelsmann the preferred content provider for the new firm.

Although the merger would give Terra, the Internet division of Telefónica de España SA, access to English-speaking customers in the U.S. and beyond, the language barrier could create difficulties in merging the companies' resources and staffs. Terra's chairman, Juan Villalonga, answered questions in both English and Spanish at the press conference announcing the deal.

When asked how the new company would compare with the powerhouse created by the AOL-Time Warner Inc. (TWX) merger, Villalonga replied, "We don't like to compare ourselves to any other company, but we can say, as of today, AOL has a competitor."

Villalonga would serve as Terra Lycos' chairman. Bob Davis, CEO of Lycos, would become CEO of the new company, which would be based in the U.S.

The merger, unanimously approved by the boards of both companies, marks the first purchase of a U.S. Internet company by a European ISP. Europe's second-largest Internet company would be united with the fourth-largest portal in the U.S., providing each company with access to features it lacks: Terra would get content, and Lycos would get the reach of an access provider. A raft of similar alliances could be on the way.

"The bottom line is you'll see a lot of pairing up of phone companies, whether national or international, and robust content pure-plays," says Emily Meehan, an analyst with the Yankee Group, a technology research firm in Boston. "The phone companies are realizing they're lacking something; the content companies realize they need an entry point into the broadband market."

The deal would give Lycos a dominant position in Latin America, where Terra is already among the top-three Internet players, with a particularly strong position in Brazil, which accounts for half of all Web users in the region.

"Terra certainly brings a big footprint in the Latin world, and it brings captive traffic - its subscribers," says Tom Anthofer, a managing director at investment banking firm Broadview International. "Terra can benefit from Lycos' technology, the content aggregation skills that Lycos clearly has, and its media mind-set."

Latin America is currently the fastest-growing region worldwide for Internet hosts, and Spanish speakers number about 500 million in the region, including the U.S. and Spain. According to research group International Data Corp., Latin America has about 8 million people on the Net and that number should soar to nearly 30 million by 2003, which will still only be 5 percent of the total population. By that time, e-commerce figures are projected to reach $11.5 billion.

Although Lycos has launched operations in many Latin American countries since the beginning of this year, its presence has gone largely unnoticed. The company has not generated substantial traffic for its portal site and is way behind top regional players such as Terra, Brazil's UOL, New York-based StarMedia Network Inc. (STRM) , Miami-based Yupi Internet Inc. or Argentina's El Sitio Inc. (LCTO) .

But even the largest U.S. companies, such as AOL and Yahoo Inc., have so far failed to make major inroads into Latin America. AOL, for its part, launched operations in Brazil late last year and immediately ran into trouble after the media reported consumer complaints that the CD with AOL's proprietary software damaged their desktop configurations. Also, AOL's Brazilian president, Francisco Loureiro, left two weeks after the company's much-publicized debut.

Others, like Yahoo, have taken a low-profile, long-term perspective toward Latin America and are counting on "viral marketing" - Internet jargon for mouth-to-mouth propagation - to grow.

Terra is considered the strongest player in the region, not only because it is swimming in cash after its highly successful IPO, but because it has the backing of Telefonica de Espana, its main shareholder and one of Latin America's dominant telcos. In a region where free Internet access is growing fast and the telecommunication infrastructure has created a significant bottleneck to the Internet's development, Telefonica's support is seen as crucial.

In the post-Nasdaq crash climate, consolidation in Latin America is seen as an inevitable trend. The region will be able to support no more than three category-killers, analysts contend.

After its IPO, Terra went on a shopping spree for successful regional dot-coms and content deals, and it is among the few Latin ISPs with the cash to keep on buying. Early this year, Terra signed a record $68 million deal with Brazil's fourth-largest media group, Estado, for exclusive rights to its publications, sending a loud message that content will be crucial in the years to come.

"We still believe that there are services that people will be willing to pay for, and content will be the difference," said Marcelo Lacerda, director of Terra in Brazil.

Even before the Terra-Lycos rumor, the region had been awash with speculation of Terra mergers. The loudest has involved a Terra acquisition of StarMedia, but other presumed targets have included Globo.com, a portal recently launched by Brazil's Globo.

Daniel Helft in Argentina contributed to this story.