Index. Highlights 1. Letter to our shareholders 2. Operating results 4. Comments on the financial position 14. Fundación TELMEX 20

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2 Index Highlights 1 Letter to our shareholders 2 Operating results 4 116,848 Comments on the financial position 14 Fundación TELMEX 20 Audit Committee Report 21 Evaluation and Compensation Committee Report Total Revenues (million pesos) Finance and Planning Committee Report 23 Consolidated financial statements Proposal to the Meeting 45 Significant results of accounting separation of local and long distance telephone services 46 Board of Directors 47 Advisory Board 48 Directory Operating Income (million pesos) EBITDA (million pesos) 39,539 60,233

3 Highlights ( figures in millions of pesos, unless otherwise indicated, with purchasing power at December 31, 2003 ) TELMEX, a corporation made up of Teléfonos de México, S.A. de C.V., its subsidiaries and affiliates, provides telecommunications services. The company s service coverage includes the operation of the nation s most complete local, domestic and international long distance fixed networks as well as interconnection services to other telecommunications operators. Additionally, it offers services like connectivity, Internet access, collocation, web hosting, produces and distributes telephone directories and sells telecommunicationsrelated equipment. Financial results Total revenues 116, , , , ,478 Cost of sales and services 27,069 26,591 26,466 25,307 22,142 Commercial, administrative and general expenses 17,246 17,206 18,836 18,935 18,284 Interconnection 12,300 11,936 10,782 7,890 3,161 Depreciation and amortization 20,694 20,346 18,969 19,424 20,322 Total costs and expenses 77,309 76,079 75,053 71,556 63,909 Operating income 39,539 41,162 46,811 45,557 42,569 EBITDA 60,233 61,508 65,780 64,981 62,891 Net income from continuing operations 22,450 20,347 25,822 28,683 26,063 Assets from continuing operations 185, , , , ,778 Debt from continuing operations 68,678 68,766 76,651 85,384 61,110 Stockholders' equity (1) 79,649 63,598 55,791 56, ,901 Statistics Lines in service (2) 15,683 14,446 13,372 12,069 10,878 Internet access accounts (2) 1,452 1, Line equivalents for data transmission (2) 2,291 2,021 1, Domestic long distance minutes (3) 15,376 14,347 14,251 12,309 10,419 Internatinal long distance minutes (3) (4) 4,513 4,922 4,404 5,521 4,192 Total local calls (3) 26,494 25,679 25,567 24,738 23,426 Sold telephone cards (3) Data per share (pesos) (5) Net income from continuing operations Basic Diluted Nominal dividend paid Outstanding shares at the end of each year (3) (5) 12,109 12,777 13,165 14,010 14,949 (1) The decrease in the value of stockholders' equity in 2000 was due to the spin-off of América Móvil (2) Thousands (3) Millions (4) Includes incoming and outgoing traffic (5) Considers in retroactive form the effect of the stock split approved since February 1, 2000 [ 1 ] telmex annual report 2003

4 Letter to our shareholders Dear Shareholders: 2003 was another demanding year for TELMEX as the company faced challenges that were common throughout the telecommunications industry. One such challenge was the ongoing technological evolution which forces all companies to review and potentially modify their business models. Another challenge came from the effects of low economic growth rate in Mexico and the recession in the United States of America. Nevertheless, TELMEX has continued to deliver important achievements that are reflected in our solid financial position and market leadership. These accomplishments distinguish TELMEX among telecommunications companies globally and led to our being recognized by Forbes magazine as the best in our industry worldwide. The challenging economy notwithstanding, TELMEX has kept its commitment to modernization and infrastructure growth. We have increased the number of services that we offer and have made notable advancements in the modernization of our transport and access infrastructure, which allows us to expand our relationships with customers. Although economic conditions have made it prudent to rationalize our investment program, we have restrained spending without adversely affecting the quality and modernization of services and without losing momentum for internal growth. One example is the corporate network management business, in which TELMEX s leadership is unquestioned. We have also extended our coverage and service offering to our customers. At December 2003, 58.9 percent of the population had access to broadband services, and that will expand to more than 70 percent in the first months of Additionally, 89.8 percent of the population with voice service can access the Internet through a single local call. In social telephony, initiatives focused on prepaid plans and the expansion of telephone coverage through public and rural telephony platforms. We promoted Multifon service for customers who need to control their telephone expenses and as a tool to make our operations more efficient in rural areas. Our effort enabled us to triple Multifon Hogar lines in 2003, reaching more than 639 thousand at year-end. The public and rural telephone platforms ended the year with 725 thousand public phones in operation. During 2003, we sold the equivalent of 2.8 telephone cards per person. These services were key contributors to our ability to deliver telephone services to the part of the population that has low purchasing power. Rural telephony has been a priority for TELMEX and a fundamental part of our strategy even without any subsidy for providing these services. During 2003, rural telephony accounted for 8.5 percent of total investment and focused on automation, growth, and modernization of the current infrastructure, as well as the introduction of broadband Internet access, which reached 543 communities in the country at year-end. telmex annual report 2003 [ 2 ]

5 During the year, the presubscription process brought another 239 cities into the competitive long distance market, raising the total to 1,844. These cities accounted for 81.3 percent of lines in service and generated 88.8 percent of total long distance minutes. In the last six years, interconnection rates have been reduced 70.8 percent in real terms, positioning them at international levels. The increase in interconnection ports along with the reduced number of local districts, in comparison with more developed countries like the United States, has helped make Mexico a highly competitive telecommunications market. This was particularly evident in the 19.1 percent year-over-year increase in traffic that our competitors handled over TELMEX s network in We support activities that strengthen Mexico s competitive environment and are committed to further development of the nation s telecommunications industry. In an environment in which rates continue to decline, we have maintained market leadership and our competitive position by following a disciplined approach to define and execute the investment program while paying day-to-day attention to expenses and thoroughly analyzing basic operating processes. Organic growth allowed us to keep revenues stable in real terms, in spite of not increasing rates for the third consecutive year. That, along with a strict cost control focus and increased efficiencies allowed us to reduce the negative impact on operating margins. We will continue this effort during Even in difficult times priorities for TELMEX include productive capital investments complemented by ongoing investment in research and development. In conjunction with our technology suppliers, we have developed specific applications for creating new products and services, and we have modified processes to reflect the new market requirements. Additionally, we have maintained our commitment to promote the digital culture through research and development of new technologies and to apply technology to solve domestic challenges, in particular those related to education and health. During 2003, we allocated more than 400 million pesos for these purposes. From the financial perspective, we took advantage of low interest rates to obtain a better combination of rates and maturities in the company s debt profile, while assuring continued access to the necessary resources to support our operations. In keeping with TELMEX s adherence to good corporate governance practices, the Board of Directors and the Audit, Evaluation and Compensation and Finance and Planning Committees met regularly during the year to supervise the operation and proper performance of the company at all times. The reports of the various committees are part of this annual report. Additionally, the Shareholders, at their annual meeting in 2003 approved a 10.7 percent increase in the cash dividend. Through the share repurchase fund, during the year we acquired the equivalent of 5.2 percent of the outstanding shares at December 31, TELMEX s social commitment was evident in 2003 as well, as Fundación TELMEX contributed throughout the year to assist our country s initiatives in education, health nutrition, and culture. The foundation s outreach directly benefited more than 183 thousand persons and thousands more indirectly through different programs that are detailed in this report. TELMEX has excellent potential for growth in the Mexican market. We will capitalize on those opportunities by continuing to expand our footprint and further penetrating the markets for both basic and integrated telecommunications services. Our depth of experience, our human resources, and our solid financial structure will enable us to expand in new markets in Latin America, in order to take advantage of opportunities that arise to develop telecommunications, to serve our international customers and, in these ways, to create value for our shareholders is filled with challenges; nevertheless, all of us who work at TELMEX will continue to be committed to our responsibilities. We recognize and thank all of our employees for their effort, dedication, and continued participation in training and you, our shareholders, for your support. Thank you. Carlos Slim Helú Jaime Chico Pardo Chief Executive Officer Carlos Slim Domit Co- [ 3 ] telmex annual report 2003

6 [ Anticipating our customers needs is an essential element in our commitment to pay attention to customers and deliver a high level of service. TELMEX works every day to improve and develop our product offerings in order to attract new customers and maintain market leadership. In 2003, our marketing initiatives emphasized value-added services like digital services and prepaid plans as well as our commitment not to increase rates. telmex annual report 2003 [ 4 ]

7 Our primary strategy for the mass market in 2003 was to acquaint customers with the advantages of integrated telecommunications solutions. Thus, our marketing programs emphasized packages that promoted line sales in facilities, long distance calling, voice mail, digital services, Internet access and prepaid options. TELMEX has 376 stores, which represent our primary channel of attention and service for residential customers. In the corporate market, the strategy focused on becoming our customers partner by integrating telecommunications products and services, offering market-leading quality and competitive pricing, and providing a single point of contact. Large and small companies alike benefit from that kind of partnership in their everyday interactions with their suppliers and customers. Lines in service In 2003, TELMEX added more than 1 million 200 thousand lines. The ratio of installations to disconnections also improved, to 3.2 from the previous year s 3.0 installations per disconnection, based on 1,798,729 installations and 561,901 disconnections resulting in a gain of 1,236,828 lines, 15.1% more than in Of the total lines added during 2003, 1,105,155 were residential lines and 131,673 were commercial lines. At year-end 2003, TELMEX had 15,683,264 telephone lines in operation, an annual increase of 8.6%. Multifon (prepaid lines) Marketing for Multifon prepaid services focused on customer segments that typically limit their expenditures for telephone service, including rural areas where prepayment is a common household money management tool. The popularity of prepaid services also helps TELMEX lower customer credit risk. At year-end, there were 639,190 Multifon Hogar lines in service, an increase of 199.5% compared with the previous year. Multifon Hogar lines represent 4.1% of the company s total lines. Digital services In 2003, the continued promotion of digital services packages, especially voice mail, demonstrated their value to new users and increased their market penetration 4.8 percentage points, reaching 35.0% of lines in service. At the end of December, 5,488,497 lines had at least one digital service, an annual increase of 25.7%. Buzón TELMEX (free voice mail) In order to offer better service to our customers, we introduced Buzón TELMEX, with no activation cost or monthly fee. At year-end, 5,355,128 lines had activated their Buzón TELMEX, representing penetration of 34.1% of total lines in service. Additionally, the new telephone sets that are being installed have the Buzón TELMEX function and caller ID, another way that TELMEX adds value to the line. Local traffic The higher number of lines in service, increased penetration for digital services and Buzón TELMEX, all had a positive impact on local traffic. For the full year, local calls rose to 26,494,million, 3.2% more than the previous year. Interconnection The long distance-local and local-local interconnection agreements that were reached with several telecommunications operators in 2002 remained in effect in Under those agreements, the interconnection rate is US$ per minute, the transit rate is US$0.003 per minute, and a charge of 75% of the automatic domestic long distance rate is applied for inter-urban transport. Traffic with local operators does not generate revenue for TELMEX because the company follows a bill and keep policy. The significant reduction of the interconnection rates and the higher number of cellular customers in Mexico contributed to a 19.1% increase in 2003 interconnection traffic to 25,790 million minutes. Local market share According to information provided by the Secretaría de Comunicaciones y Transportes (SCT) (Mexican Ministry of Communications and Transportation) on its Internet web site, the local telephony market in Mexico is comprised of 22 companies with concessions to provide local wireline and wireless telephony and 13 companies with concessions for cellular and mobile telephony. TELMEX estimates that at year-end 2003, its share of the local service market was 33.6% based on the number of users of all the local companies including cellular and mobile services. 33.6% TELMEX 66.4% Others Estimated local market share based on customers [ 5 ] telmex annual report 2003

8 Long distance TELMEX services are available in 21,358 communities, which are home to 89.8% of the Mexican population, through a digital fiber optic network that totals almost 75 thousand kilometers. TELMEX s long distance network is comprised of an international network that links Mexico to more than 40 countries, a high-capacity domestic core network, and a regional network that joins major cities across the country. The deployment and coverage that the long distance fiber optic network delivers are in constant evolution, and to date has an extension of 25 thousand kilometers. The foundation of the long distance network is an intelligent network that incorporates two critical elements in supporting a market-leading telecommunications provider: it facilitates the design and implementation of new services at the same time as it uses information technologies to support current traffic processing and management needs. In the future, investments in the long distance network will be focused on the development and deployment of new generation networks for transport, access and processing, primarily to support commercial customers by introducing services and functions that meet their diverse needs. In the long distance market, TELMEX offers a wide range of rate plans that are designed to fit market segments different needs. Examples include fixed daytime and nighttime rates, volume-related discounts and special rates for selected destinations that customers call frequently. Plan Lada 100 (Domestic long distance minutes package) In September we introduced a new commercial package that was designed to stimulate domestic long distance use and provide an economic benefit for its users. The plan, Lada 100, offers 200 domestic long distance minutes for 100 pesos per month. In only four months 637,058 customers signed up for this plan. Long distance traffic Domestic long distance traffic (DLD) increased 7.2% to 15,376 million minutes in International long distance (ILD) totaled 4,513 million minutes, a decrease of 8.3% compared with A key factor in these results was the negative impact of by-pass on international long distance incoming traffic. That illegal practice caused an estimated revenue loss of 2,530 million pesos, equivalent to 28.0% of the company s ILD revenues. Concurrently, we will drive the intelligent network toward a new generation platform in order to support new services and functions. This new generation platform will provide higher capacity to the intelligent network and facilitate the convergence of voice and data services. telmex annual report 2003 [ 6 ]

9 Long distance market share Based on information provided by the Secretaría de Comunicaciones y Transportes (SCT) (Mexican Ministry of Communications and Transportation) on its Internet web site, Mexico s long distance market in 2003 consisted of 24 companies with concessions to provide long distance services. During the year, the presubscription process brought another 239 cities into the competitive long distance market, raising the total to 1,844. These cities accounted for 81.3% of lines in service and generated 88.8% of total long distance minutes during According to information from NCS Pearson, an independent company that tracks customers requests to switch providers, from 1997 to 2003 customers made 27,418,525 changes in long distance operators, evidence of the dynamic competition in this market sector. Based on the company s traffic estimates, TELMEX had an average market share in the cities open to presubscription of 75.6% in domestic long distance and 74.6% in international long distance. Public and rural telephony Our public and rural telephony platforms enable TELMEX to provide access to telecommunications services throughout most of the Mexican territory. Important factors in that reach are our network coverage and broad distribution channel for prepaid cards. TELMEX ended the year with 725,467 public telephones in service, of which 270,733 telephones used prepaid cards with Ladatel chip technology and 372,923 were shared phones that use the Multifon prepaid card. Through our distribution network of more than 166 thousand points of sale, TELMEX sold million Ladatel cards and 13.2 million Multifon cards, an increase of 1.8% compared with the total number of sold cards in the previous year. Rural telephony has been an important part of the company s connectivity expansion. Through the e-telmex project, broadband connection is available to 543 rural communities, and another 2,407 communities have dial-up Internet access. In 2003, service was improved in 1,279 communities through VSAT technology (Very Small Aperture Terminal). This resulted in an increase of five lines per community, raising the total to 6,395 lines to improve service and meet the demands of domestic and international traffic. Additionally, this technology brought another 281 communities with 1,686 lines onto the TELMEX network. At year-end, TELMEX had 13,744 lines in operation through VSAT. During 2003, telecommunications services were introduced in 654 communities with the installation of 115,536 lines. At year-end, 544,278 rural customers had telecom services in their homes. Multifon Kit provided the main product for achieving this reach, with additional support coming from the promotion of value-added services like digital services, access to Prodigy and Buzón TELMEX. At year-end, TELMEX provided telephone service to 13,399 rural Mexican communities. TELMEX s Technical and Long Distance Department was honored with ISO 9001 certification based on requirements stipulated in 2000, the first certification of this type in the world. The department was recognized for its implementation of an integrated management system that standardizes processes, measurements, time, and objectives and work criteria in order to guarantee quality, order and control in long distance services throughout the country. DLD (Average market share based on traffic in cities under presubscription) 75.6% TELMEX 24.4% Others 74.6% TELMEX 25.4% Others ILD (Average market share based on traffic in cities under presubscription) [ 7 ] telmex annual report 2003

10 [ We have expanded our footprint and introduced new products and services that allow our customers to make better use of their telecommunications services. We have continued to expand our network, both by adding communities and increasing broadband service offerings that improve connectivity for our customers. telmex annual report 2003 [ 8 ]

11 Data At TELMEX, we seek to be our customers technological partner in order to support their integration into the global environment. Because of that close relationship, we have been able to integrate solutions in data transmission and Internet access that allow customers to maximize their use of technological advances to satisfy their personal and professional telecommunications needs. Prodigy Internet Plus In order to increase PC penetration, we offered our customers attractive plans for Internet access that included financing of their computer equipment. At year-end, TELMEX had 301,403 access accounts with personal computers through the Prodigy Internet Plus package. From the launch of Prodigy Plus package through year-end 2003, TELMEX has financed 613,659 personal computers. Prodigy Internet In 2003, we added 286,937 Internet access accounts, an annual increase of 24.6%. At year-end, there were 1,452,338 Internet access accounts in operation, 86.6% of which were dial-up. At year-end, 89.8% of the Mexican population that uses voice services was able to access the Internet through a local call. Prodigy Infinitum (ADSL) The fastest growth rate occurred with Prodigy Infinitum, which provides access to broadband, or ADSL (Asymmetrical Digital Subscriber Line). Prodigy Infinitum ended the year with 179,293 customers. Additionally, at year-end broadband service coverage was available in 970 major cities in Mexico, which accounted for 58.9% of the population. On December 20, we began offering customers double the speed of Prodigy Infinitum services of 256 Kbps and 512 Kbps for the same monthly rate and no additional installation charge. This service allows us to broaden the number of online applications that customers can manage through their connection. Moreover, it provides TELMEX with a platform for the development of new applications and services that demand more broadband. Prodigy Móvil (mobile Internet) TELMEX s mobile Internet offering has been well received by customers, with more than 56 thousand subscribers at year-end. This service is based on standard industry technology known as WiFi and allows customers to access high-speed Internet from public sites. With 279 public sites in the major cities of the country, our next step will be to provide international roaming for customers. Thanks to the constant technological evolution of Internet services and the transformation of these advances into concrete solutions, we can offer our customers mobility without sacrificing the high levels of service quality on which they depend. In the corporate market, for example, Prodigy Móvil enables users to connect to the network without cables using Prodigy Hospitality service from their own buildings or elsewhere, because we provide public access in hotels, hospitals, airports, universities and other locations Line Equivalents for Data Transmission (thousands) 2,291 Data Business (thousand units) Service % Inc. Internet access accounts 1,452 1, Prodigy (dial-up) 1,258 1, Prodigy Infinitum (ADSL) Line equivalents for data transmission 2,291 2, ,452 Internet Access Accouts (thousands) [ 9 ] telmex annual report 2003

12 Soluciones de Crecimiento Inmediato (Immediate Growth Solutions) In 2003, TELMEX introduced Soluciones de Crecimiento Inmediato (SCI, or Immediate Growth Solutions) for small businesses. These services provide a viable and attractively priced alternative to setting up their own internal telecommunications network by integrating telephony services, access to broadband Internet, personalized accounts and advertising in Internet yellow pages for a fixed monthly rate that varies according to the package that customer selects. Seccionamarilla.com.mx (Yellow pages) The yellow pages portal, in 2003 averaged monthly page views of 1 million 142 thousand, 37.9% higher than the monthly average in Additionally, the number of unique users of the portal increased 58.4% compared with the previous year, reaching a monthly average 0f 629 thousand users in ProdigyPymes.com (Small and medium-sized businesses portal) The ProdigyPymes portal, is an Application Service Provider with computer services and applications for small and medium-sized businesses. Its programs and data run through our Prodigy Data Center. In the near term, efforts at TELMEX, in conjunction with the best software providers in Mexico, will be focused on broadening the portal s catalog of products and services. In addition to the advantages that broadband offers through the Internet, ProdigyPymes enables its customers to access management applications for a monthly fee. The added service guarantees that they have the most up-to-date version of the application along with the benefit of information backup. Additionally, customers participate in the Eficentrum Club de Compras Pymes (Eficentrum Pymes Buying Club), the largest digital market in Latin America. It offers small and medium-sized businesses opportunities to improve their purchasing capacity by getting competitive prices for industrial materials, equipment, furniture and other goods. Company Attention To provide specialized consulting and a point of sale for micro and small businesses we established the Centro de Comercialización Remota, or CECOR (Customer Attention Center). As an added benefit, we have reached agreements with the nation s leading chambers and corporate associations to provide their members with the most advanced telecommunications services at accessible prices. In this way customers have access to the tools that allow them to improve their communication and make their internal processes more efficient. In order to meet the market needs of medium-sized businesses, commercial channels were enhanced to give our customers more personalized attention and consulting to make the best use of their investments in technology. Through TELMEX representatives, we have been able to drive the sale of products like Prodigy Infinitum (ADSL), Internet Directo Empresarial, digital trunks and Uninet. Companies benefit from having a single point of contact that provides consulting and support to solve the specific telecommunications needs to their industries. For this reason we have sales forces identified with specific market telmex annual report 2003 [ 10 ]

13 segments. They design and implement integrated solutions that involve equipment, access, transport, applications, hosting, collocation, content and consulting. This kind of expertise helps customers obtain greater efficiencies in their businesses by implementing telecommunications programs that fit their needs. TELMEX s ability to support efficient communication among our customers various branches, factories or offices and with their suppliers, customers and government officials represents a strong competitive advantage. Today, it is possible to have multimedia communication with flexible broadband, the best technology and extensive coverage, all at an attractive price. This kind of presence and strength have made TELMEX a valued technological partner for the country s large corporations and institutions, which trust us with the management and backup of their networks. In the corporate market, 270,319 Lada Enlaces (Line equivalents for data transmission) were added during the year. At the end of 2003, TELMEX had 2,291,111 Lada Enlaces in operation, 13.4% more than the previous year. International expansion TELMEX s experience with offering telecommunications solutions in Mexico provides a foundation for the company to expand regionally. In November 2003 TELMEX began its international expansion through the acquisition of telecommunication assets in Argentina, Brazil, Colombia, Chile and Peru. Latin America represents great potential for the telecommunications industry due to economic recovery and the relatively low penetration level for voice and data transmission services in the region. The acquisition expands growth opportunities in Latin America because we will be able to apply the synergies available in offering voice, data and Internet services in each of these countries as well as regionally, including connecting with our operations in Mexico. Our strategy will be to establish a regional product and services offering that initially is directed to the corporate sector. Our early efforts will be focused on optimizing the cost structure of these subsidiaries by achieving economies of scale in investments and management, in addition to improving operating efficiencies by introducing best practices in the different countries and implementing a management model similar to the one we use in Mexico. Increased participation in the Latin American telecommunications market is an opportunity for TELMEX to demonstrate solid growth by building on our foundation of technological and market knowledge, enhanced by our network investment and proven ability to develop staff. [ 11 ] telmex annual report 2003

14 [ A disciplined approach to balancing investment in our future with day-to-day attention to expenses is an ongoing process for TELMEX. In 2003 we continued to strengthen our basic operating processes to eliminate deficiencies and, in this manner, control and reduce our operating costs and expenses. telmex annual report 2003 [ 12 ]

15 Management and control of operating costs and expenses In order to have a more efficient operation, we identified the most important items in operating costs, excluding depreciation, amortization and interconnection, where expense-reduction measures could be applied without adversely affecting the operation of the company. To ensure that cost-reduction measures became a permanent part of operations, we instituted a centralized financial management process to anticipate our variations from budget and cost-reduction targets and to avoid losing control over those expenses. As part of the process we signed new contracts with key suppliers to deliver better productivity and lower maintenance costs in our internal and external infrastructure and in systems. We implemented regular reviews of strategic contracts to establish schedules for delivery of covered services and to monitor how the contracts are managed. As we evaluated the most effective ways to avoid service interruptions caused by infrastructure-related incidents, we decided, whenever possible, to rely on the well- trained TELMEX staff and solve problems internally rather than use a supplier. In support of that decision, we institutionalized a process management system that enables us to compare repair costs between our suppliers and TELMEX. Regarding materials, we also implemented planned repair, rehabilitate and rationalization programs that allow us to reduce costs without diminishing service quality. Additionally, in the internal plant we set up inventory control systems, particularly pertaining to switching and transmission equipment, that are core supplies for our business. The introduction of the Sistema de Administración Telefónica, or SIATEL (Telephone Management System) in 1999 has resulted in better control of management and supply processes. In October 2002, we initiated testing of the integration of SIATEL with the e-commerce Eficentrum portal. In 2003, the integration of the two systems reduced the supply cycle 30% from the placement of the order to the delivery of the items in the areas of systems, external plant, non-telephone equipment and supplies. Capital expenditures Infrastructure considerations make telecommunications an intense business because of the challenges inherent in budgeting significant capital expenditures appropriately while still developing the network at the proper pace to meet future demand. TELMEX continued to review capital spending plans, cutting back on programs that did not directly affect service and without affecting its organic growth. In 2003, capital investment amounted to 996 million dollars, 12.5% lower than During the year, we added 1,794,084 services including fixed lines, Internet access accounts and line equivalents, that together accounted for line growth 1.1% ahead of the previous year. Total services grew 10.2% to 19,426,713 telecommunications services. Our capital investment was made more productive by working with our suppliers to implement best practices. We approach our supplier relationships from the customer perspective. As a result, we are focused on priorities such as increasing high-speed connectivity in the last mile, using technological advances to simplify network architecture, reducing operating cost and ensuring that the operating system platform can accommodate new services in the near future. The changes that, we made in the network itself along with new technologies helped reduce both equipment acquisition and operating costs during the year. During 2003, we carried out updates and renovations in 3,912 districts, replacing obsolete elements and preventing weak conditions in the network. This rehabilitation also prepared the network for future applications in data and value-added services. For the third consecutive year, Global Finance magazine designated TELMEX as the best Telecommunication Company in Latin America. Among the most important criteria in selecting the best companies were technology, strong management, market development, revenues, profitability, market capitalization growth and social responsibility. [ 13 ] telmex annual report 2003

16 Comments on the financial position The consolidated statements of income of TELMEX reported in the following pages should be analyzed in conjunction with the comments on the operating results, the consolidated financial statements and accompanying notes, which are an integral part of this annual report. In accordance with Mexican Accounting Principles Bulletin B-10, Accounting Recognition of the Effects of Inflation on Financial Information, issued by the Mexican Institute of Public Accountants, the figures shown in the financial statements and the accompanying notes, as well as the ones included in this section, are expressed in pesos with purchasing power as of December 31, TELMEX Consolidated statements of income Million % of operating Million % of operating Million % of operating Years ended December 31 pesos revenues pesos revenues pesos revenues Operating revenues: Local service 53, , , Long distance service: Domestic 30, , , International 9, , , Interconnection 17, , , Others 5, , , , , , Operating costs and expenses: Cost of sales and services 27, , , Commercial, administrative and general 17, , , Interconnetion 12, , , Depreciación y amortización 20, , , , , , Operating income 39, , , Comprehensive financing cost: Interest income ( 2,990 ) ( 1,307 ) ( 1,406 ) Interest expense 5,579 6,286 7,690 Exchange loss (gain), net 3,133 4,622 ( 1,273 ) Monetary gain, net ( 1,652 ) ( 2,906 ) ( 2,370 ) 4,070 6,695 2,641 Income before income tax and employee profit sharing 35,469 34,467 44,170 Provisions for: Income tax 10,255 10,736 14,594 Employee profit sharing 2,585 3,122 3,281 12,840 13,858 17,875 Income before equity in results of affiliates 22,629 20,609 26,295 Equity in results of affiliates ( 179 ) ( 262 ) ( 473 ) Net income 22,450 20,347 25,822 telmex annual report 2003 [ 14 ]

17 Local service revenues In 2003, revenues from local service were 53,871 million pesos, a 2.5% decrease compared to The decrease was mainly due to lower real rates since nominal rates were unchanged in Additionally, billed traffic increased by only 0.9% due to the weak performance of the Mexican economy, partially offset by higher penetration of digital services (35.0% in 2003 compared with 30.2% in 2002) and the increase of lines in service (8.6% in 2003) that resulted in higher revenues in rent of telephone services. Revenues from local service decreased by 4.0% to 55,228 million pesos in The decrease in 2002 revenues was attributable to (i) lower real rates, (ii) a decrease in the number of billed local calls and (iii) fewer installations of new lines compared to Real rates declined due to inflation, as nominal rates were unchanged. The reduction in billed traffic in 2002 was attributable in part to the weak Mexican economy, but it also reflected a trend in recent years whereby the number of billed local calls per line has declined from 132 in 1999 to 93 in This decline is a result of lower marginal local call traffic for new lines in service due to the penetration of service to populations with less disposable income, the displacement of fixed-line local service by other means of communication such as the Internet, cellular phones and private circuits, and competition from other local operators. Total local revenues contributed 46.1% to total revenues in 2003 compared with 47.1% in 2002, a year-over-year decrease of 1.0%. Domestic long distance revenues (DLD) Domestic long distance revenues (DLD), which include connectivity and Internet services revenues, rose to 30,514 million pesos in 2003, 1.5% higher than in This increase was largely due to higher demand for Internet access, partially offset by declining real rates and several discounts for connectivity services. Revenues from connectivity service decreased by 11.7% in 2003 and 11.4% in 2002, while Internet service revenues increased by 29.6% in 2003 and 25.8% in The DLD contribution to TELMEX s total revenues was 26.1% in 2003 and 25.6% in 2002, an increase of 0.5%. In 2002, DLD revenues were 30,054 million pesos, 4.1% lower than in The decrease was due to lower real rates and customer discounts for long distance service and connectivity services, partially offset by increased demand for Internet access. International long distance revenues (ILD) International long distance revenues (ILD) were 9,041 million pesos in 2003, a decrease of 8.2% compared to The decrease was mainly because the volume of billed traffic was not enough to offset the reduction of rates in real terms and to lower incoming traffic caused by the illegal practice of by-pass. TELMEX estimates a revenue loss of approximately 2,530 million pesos in 2003 compared with 1,680 million pesos in 2002 that is attributable to illegal by-pass practice. Both amounts include illegal by-pass from incoming traffic that is registered as domestic long distance or local traffic, as well as international incoming traffic not reported to Galaz Yamasaki, Ruíz Urquiza, S.C. auditors (member of Deloitte Touche Tohmatsu) by the international operators during Bypass levels are reflected by the difference between traffic detected by our systems and traffic reported by carriers to this auditor. The balance of non-reported traffic reduces our share of the proportional return on incoming traffic. It is important to mention that this illegal practice of traffic was not reported in 2002 because it was not detected. ILD s contribution to TELMEX s total revenues was 7.8% in 2003 and 8.4% in 2002, a decrease of 0.6%. In 2002, ILD revenues were 9,848 million pesos, a decrease of 4.9% compared to The decrease was primarily due to (i) lower real rates billed in Mexico, (ii) slightly lower outgoing traffic and (iii) reduced international settlement rates, all of which were partly offset by higher incoming traffic, principally from the United States. Revenues from interconnection Revenues from interconnection represent fees from our customers for fixed-to-mobile calls and fees from other providers of local, long distance and mobile service for connection to our local network. [ 15 ] telmex annual report 2003

18 Comments on the financial position Under the calling party pays system, our fixed-line customers pay us an interconnection charge when they call mobile customers. The contribution of interconnection revenues to the total revenues of the company increased by 1.2% from 13.8% in 2002 to 15.0% in Interconnection revenues increased by 8.6% in 2003 totaling 17,565 million pesos, mainly due to the increase in minutes from calling party pays and long distance operators. In 2002, interconnection revenues increased by 0.1% due to growth in calling party pays minutes, partially offset by lower interconnection fees from long distance carriers. Revenues from fixed-to-mobile calls represented 92.3% of total interconnection revenues in 2003 and 93.0% in Interconnection revenues from competing local and long distance carriers represented 6.1% in 2003 and 5.4% in The remaining 1.6% of interconnection revenues represents payment from cellular operators in both years. In December 2002, we reached agreements with competing long distance carriers that reduced the interconnection tariffs by 22.0% compared with In 2003, the nominal rate remained at US$ per minute. Other revenues The largest components of other revenues are sales of yellow pages advertising and telecommunications equipment and accessories and billing and collection services offered to third parties. In 2003, other revenues decreased by 1.3% principally due to lower revenues from yellow pages advertising and network maintenance services, partially offset by higher revenues from the sale of telecommunications equipment and accessories in TELMEX stores (Tiendas Telmex) and billing and collection services charged to third parties. In 2002, other revenues decreased by 8.8% due to lower revenues from network maintenance services and yellow pages advertising. Cost of sales and services Cost of sales and services increased by 1.8% in The increase was mainly due to higher expenses in pensions and seniority premiums, the increase of electricity rates and higher costs for telephone sets and computers, partially offset by decreased expenses for maintenance of outside plant and systems, as well as lower expenses for the production of telephone directories. In 2002, cost of sales and services increased by 0.5% due to a higher volume of computers sold for Internet service. Eliminating the cost of computers sold in both years, cost of sales and services decreased by 1.3% in Commercial, administrative and general expenses In 2003, we maintained strict cost control policies, including the continued reduction of marketing expenditures and the reduction in the cost of prepaid cards. This cost control policy helped reduce the impact of higher expenses in pensions and seniority premiums and higher payments to third party service providers. As a result, commercial, administrative and general expenses remained almost at the same level as last year. In 2002, commercial, administrative and general expenses decreased by 8.7%, due primarily to a reduction in marketing for telephone services and the reduction in the cost of Ladatel cards. In addition, in 2002 there were no contributions to Fundación TELMEX. Interconnection Interconnection costs increased by 3.0% in 2003 and 10.7% in The increases in both years were due primarily to the increase in traffic from our network to the network of cellular operators as a result of the growth in the number of cellular users. Depreciation and amortization During 2003, depreciation and amortization increased by 1.7%. Depreciation and amortization were higher because the rate of devaluation exceeded the rate of Mexican inflation and the useful life of certain assets decreased. These effects were offset by a decrease in the amount of depreciable assets. In 2002, depreciation and amortization increased by 7.3% due to the restatement of the value of foreign assets and to new investments made by the company during the year. telmex annual report 2003 [ 16 ]

19 Operating income In 2003, operating income decreased by 3.9%, reflecting a 0.3% decrease in revenues and a 1.6% increase in operating costs and expenses. As a result, the operating margin decreased by 1.3% to 33.8% in In 2002, operating income decreased by 12.1%, reflecting a 3.8% decrease in revenues and 1.4% increase in operating costs and expenses. As a result, the operating margin decreased by 3.3% to 35.1% in 2002 from 38.4% in Comprehensive financing cost In 2003, comprehensive financial cost was 4,070 million pesos compared with 6,695 million pesos in The changes in each component were as follows: Interest income increased by 128.8% in 2003 and decreased by 7.0% in The increase in 2003 was mainly due to the unrealized profit of 1,841 million pesos from our investment in bonds of MCI, Inc. (MCI) (formerly known as WorldCom, Inc.). In 2002, interest income decreased due to lower interest rates in Mexico and abroad and a lower average level of interest-bearing assets. Interest expense decreased by 11.2% in 2003 due to lower average interest rates, the recognition of a charge of 457 million pesos in our swap contracts and an additional charge of 962 million pesos related to the replacement of peso-denominated interest-rate swaps for swaps with more attractive interest rates. In 2002, we recognized a charge of 303 million pesos under our swap contracts and had an unrealized loss of 1,123 million pesos in marketable securities (including unrealized losses of 639 million pesos on MCI shares). In 2002, interest expense was 18.3% lower than in 2001 as a result of a lower level of peso indebtedness, a higher proportion of indebtedness in foreign currency and lower Mexican and foreign interest rates. In 2003, the depreciation of the peso against the U.S. dollar by 9.0% resulted in a net exchange loss of 3,133 million pesos. In 2002, the peso depreciated by 12.8% against the U.S. dollar, resulting in a net exchange loss of 4,622 million pesos, compared to a net exchange gain of 1,273 million pesos in In 2002 and 2003, average monetary liabilities exceeded average monetary assets, resulting in a net gain from monetary position. The net gain in monetary position decreased by 43.2% in 2003 due to a lower net monetary position and a lower inflation rate. The increase registrated in the net monetary gain in 2002 was 22.6% because of higher inflation, offset by a reduction in the net monetary position. Net income Net income increased by 10.3% in The increase in net income was principally due to a 39.2% decrease in comprehensive financing cost and a 7.3% decrease in the provision for income tax and employee profit sharing. Net income decreased by 21.2% in The decrease was mainly due to lower operating income and exchange loss due to the devaluation of the peso. Financial structure The debt-to-capitalization ratio was 46.3% in 2003 and 52.0% in 2002, which was within the range achieved by most telecommunications companies. Share repurchase program We have continued with our share repurchase program. In 2003, we repurchased million series L shares for an aggregate amount of 11,415 million pesos and 3.9 million series A shares for 67 million pesos. The shares purchased in 2003 reduced our capital stock by 11,482 million pesos. In 2002, we repurchased million series L shares for a total amount of 6,440 million pesos and 1.4 millions series A shares for 22 millions pesos. Our capital stock was reduced by 6,462 million pesos in At year-end, there were 12,109 million shares, 4,136 million series AA shares, 265 million series A shares and 7,708 million series L shares outstanding. [ 17 ] telmex annual report 2003

20 Comments on the financial position Dividend payments We paid dividends of 7,623 million pesos in 2003, 7,498 million pesos in Pension fund In 2003, we made tax-deductible additional contributions to the TELMEX pension fund, based on changes in the actuarial value of our future pension obligations. We contributed 4,000 million pesos in January 2003 and 3,996 million pesos at the end of We expect that additional contributions in 2004 will be at a lower level that in Capital expenditures Our capital expenditures were 996 million dollars in 2003, a decrease of 12.5% compared with We expect that our capital expenditures for 2004 will be approximately 1.7 billion dollars. Our budgeted amount excludes any other investments we may make in other companies. For subsequent years, our capital expenditures will depend on the state of the Mexican economy and market conditions. Rates In August 2003, we announced that we would not increase rates for any of our services during Indebtness During 2003, we prepaid and consolidated debt for purposes of managing our debt profile. At December 31, 2003, TELMEX had 68,678 million pesos compared with 68,766 million pesos at December 31, In 2003, TELMEX prepaid approximately 727 million dollars in outstanding debt, the repurchase of million dollars (nominal value) of our convertible debentures, and the repayment of 5,296 million pesos in maturing debt in Foreign currency-denominated debt was 1,291 million dollars, or 87.3% of the total debt, at year-end compared with 86.5% at December 31, Our long-term debt increased in November since we placed bonds worth 1 billion dollars with maturity in The bonds bear 4.5% annual interest. The bonds were sold in a private placement that ended on November 19, Included in our foreign-denominated debt are convertible debentures that bear interest at 4.25% and mature in June During the third quarter of 2003, we repurchased 190 million dollars of the convertible debentures on the open market and 1.2 million dollars of additional debentures in a cash tender offer that expired on November 6, As a result, the outstanding principal amount of debentures at December 31, 2003 was million dollars. We may continue to repurchase the debentures in the future if they can be purchased at attractive prices. The conversion price is dollars per series L shares ADS, and the ADSs have regularly traded above that price in recent months. Permanent investments a) Acquisition of substantially all of the assets of AT&T Latin America On February 24, 2004, TELMEX concluded the acquisition of substantially all of the assets of AT&T Latin America Corp., a telecommunications service provider of corporate customers in Argentina, Brazil, Colombia, Chile and Peru. The purchase price was 194 million dollars in cash and we assumed 26 million dollars in debt. AT&T Latin America was reorganized under Chapter 11 of the Bankruptcy Code of the United States of America and the Bankruptcy Court for the Southern District of Florida approved the acquisition on November 3, b) Investments in MCI We invested in equity securities and several series of bonds issued by MCI, a U.S.-based telecommunications company that is under Chapter 11 proceedings under the U.S. Bankruptcy Code. As of December 31, 2003, we held approximately 1,759 million dollars in face amount of the bonds, with a market value of approximately 589 million dollars at such date. On October 31, 2003, the Bankruptcy Court approved the reorganization plan of MCI. Under this plan, TELMEX expects to receive common stock of MCI in exchange for its bonds. The amount of stock TELMEX will receive, telmex annual report 2003 [ 18 ]