Telefonos de Mexico SAB (TMX)

Telefonos de Mexico (TMX or Telmex), headquartered in Mexico City, operates in Mexico, the other units in the U.S., Puerto Rico, Brazil, Chile, Argentina, Peru, and Columbia. Most of the South American operations that were acquired through the company's purchase of AT&T Latin America, are now a part of Telmex International (TII). The company offers a wide range of telecommunications, data and video services, Internet access, and integrated telecom solutions to corporate customers. Apart from basic fixed-line telephone services, TMX provides Internet access services telecom and telecom-related services such as directory, data transmission, and paging and interconnection services to other carriers in Mexico.

Building on its strong position in the core Mexican telecom market, TMX expanded in Latin America, primarily through strategic acquisitions. Over the past few years, the company purchased 1) a controlling interest in Embratel Participa es (a leading long-distance telecom operator in Brazil) 2) Techtel (a data service company located in Argentina) 3) a 40% interest in Chilesat (Chile's third largest long-distance company) and 4) AT&T s Latin American assets. The acquisition track brings considerable revenue expansion to TMX as it widens its regional coverage. Telephone usage still remains limited in the region and an abundant opportunity exists among untapped subscribers, particularly in the data and Internet services markets. Some months ago, TMX made a proposal for a spin-off of Telmex International, a holding company that would concentrate on TMX s international operations. On December 21, 2007, a shareholders meeting approved the proposed spin-off and recently the company was divided into Telmex and Telmex International (TII). The new "Telmex International" will be the source of growth, while the traditional Telmex will remain stagnated.

Within its core Mexican wireline business, the company has been introducing new initiatives for line and traffic additions including prepaid phone services, free voice mail, broadband and bundled calling services. During the third quarter of 2007, the company launched the Todo Mexico sin limites (All Mexico without limits) package that includes fixed line rent, broadband service, unlimited local calls and domestic long-distance minutes as well as digital services for MXN$999 per month (US$93.8). This plan is designed to suit clients' profile, increasing retention and loyalty among clients and we believe it could be successful, mainly considering the convergence strategy of the company. On October 3, 2006, the Acuerdo de Convergencia (Convergence Agreement) was established. Telmex has signed 16 interconnection agreements to date with different cable companies. The objectives established by the Federal Government regarding competition, convergence and coverage will help the fast development of the Mexican telecommunication industry, increasing penetration. Nevertheless, there have been significant delays in the issuance of the corresponding rules, postponing the technological development of Mexico. In fact, TMX has met all the requirements in the "Acuerdo de Convergencia" in a timely way, nevertheless there was no resolution from the Mexican authorities allowing the company to offer various products in the competitive market. We understand that TMX has been negatively affected by these bureaucratic delays.

TMX's business is generating modest access line retention, even worse the company has also to face lower rates. Domestic revenue per line continues to decline and VoIP and wireless substitution has resulted in a substantial market threat. Even worse, competition is increasing while the key Mexican market has stagnated and there is no positive outlook for the wireline business in the short-to-medium term. Some months ago, the Mexican Communications Ministry authorized cable television providers to provide voice-transmission services to local fixed-line telecommunications operators as well as data and broadband services to the Mexican public. In fact, Televisa (TV - the giant Mexican media group) has already started its own telecom business. On May 9, 2007, the Mexican Ministry of Communication and Transportation granted Televisa's subsidiary Cablevision a concession to offer fixed telephony services through its network. The company has 514,961 subscribers in its cable TV network and 107,534 subscribers in its broadband segment. We believe the new telephony business has been very well accepted by the Mexican market due to the limited competition in this area. In the third quarter of 2007, Cablestar S.A. de CV (a 70% owned subsidiary of Empresas Cablevision, in which Televisa owns 51% equity stake) signed an agreement to acquire the majority of the assets of Bestel, a privately held telecommunication company in Mexico for US$256 million.

The Mexican market has stagnated and Telmex continues to see a significant decrease in voice services revenues due to ongoing price cuts and fierce competition. At the end of the third quarter of 2008, including the effect of number portability that began in July 2008, the company had 17.7 million lines in service. Among these, 10.4 million are in areas that attract fixed line competitors and 7.3 million are in areas where TMX is a monopoly. In the last nine months, lines in the monopoly area generated US$1,435.5 million in revenues and US$186.4 million in operating loss. Growth in the number of telecommunications users is mainly occurring in cellular telephony. Even though fixed line competition is still small, it is growing fast and only in areas that are of key importance for TMX. Important to remember those in the areas without fixed line competition wireless operators are increasing their presence. Moreover, competition from VoIP and wireless operators has been undermining TMX's revenues in the domestic long-distance and international long-distance. We believe the only real opportunities for investments and growth is in other Latin American countries, particularly Brazil, due to its size and the continued growth of its market. In Brazil, TMX has already acquired Embratel and part of Net Servicos (NETC). We believe there will be huge synergies as Telmex Group continues to integrate its Brazilian companies. Nevertheless, after the recent separation, the business outside Mexico now belongs only to Telmex International (TII).

Total lines in service in Mexico have been decreasing slowly quarter-after-quarter. Price erosion is also a problem. In nominal terms TMX has reduced rates on all of its services for 27 consecutive quarters. However, there are some opportunities in other areas. Worth noticing was the broadband business growth in the Mexican business. In the third quarter of 2007, the company added 296,000 new subscribers to Infinitum (ADSL technology) in the fourth quarter of 2007 it was added 248,000 new customers, reaching 2.93 million customers, in the first half of 2008 it added 879,000 new customers and in the third quarter of 2008 it added 558,000 customers to the total of 4.4 million customers at the end of third quarter of 2008. Mexico has one of the highest growth rates in broadband service among all OECD countries. Particularly interesting is the fact that Telmex has been investing in the updating of its broadband product and the standard speed doubled, the new updated product is now available on 97% of the company's network with a world-class technological platform. Currently, in Mexico, only 22% of homes have a computer, which is significantly below the average of nearly 62% among the members of countries of the OECD, which means there is room for medium-term growth in this segment. Last year, Telmex has introduced a program to sell computers in monthly installments of MXN183 (US$17.20) over a period of 36 months, without obligation of acquiring Internet access. Throughout 2007, more than 240,000 computers were acquired. Recently, the company launched Paquetes SuperNegocio, the super business package for a small business designed to increase penetration of broadband services, with Infinitum and to retain and recover these customers. We believe this is a very interesting project that will create a continued market for the expansion of the internet access products in the short-to-medium term.

Third quarter 2008 results were disappointing based on the tough competition Telmex is facing as well as the current uncertain business environment throughout the world. As a result of the spin-off process in the first quarter of 2008, the company separated its Mexican domestic operation into Telmex and its international division called Telmex International. Particularly concerning is growing competition in the domestic and international long-distance segments, it is an important business in a country like Mexico since many Mexicans live abroad. In fact, domestic long-distance traffic during the third quarter 2008 was not that bad, since it increased 6.8% year-over-year. However, international long-distance traffic decreased 5.5%. Even worse, revenues in the domestic long-distance were down 12.9% year-over-year and revenues in the international long-distance declined 11.7%. It seems that TMX has been forced to reduce tariffs in order to keep traffic up. Moreover, despite having a reasonably strong financial position with EBITDA to interest and net debt to EBITDA at 8.4 and 1.4 times respectively, we anticipate potential earnings dilution in the near term as the company's debt remains a substantial liability.

Finally, based on the recent global financial crisis, we are concerned over the recession in the U.S. over the following quarters and how such an environment would impact the Mexican economy. It is important not to forget that Mexico and the U.S. have very close economic ties. We believe that TMX's current valuation is excessive if compared to other Latin American wireline operators, mainly considering the weak third quarter 2008 results and the higher worldwide inflation and interest rates, including Mexico. All considered we are keeping our Sell recommendation. We are reducing 2008 and 2009 revenue estimates.

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