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We have downgraded our long-term recommendation from Neutral to Underperform on Brazilian telecom carrier Telefonica Brasil SA (VIV - Analyst Report) following its first quarter results. The company’s first quarter earnings missed the Zacks Consensus Estimate on struggling fixed-line business.

Though the currently lagging fixed-line business is expected to benefit from the expansion of video, broadband Internet and Pay TV services, we remain skeptical about its ability to regain profitability this year. Fixed line business is significantly challenged by persistent erosion in its voice telephony business.

Additionally, competition in the local phone market remains intense and the long-distance market has matured. The impact of wireless substitution remains high as a growing number of customers are taking advantage of discounted calling plans from the national wireless operators.

Coming to mobile business, Telefonica Brasil, a subsidiary of Telefonica SA ,has attractive long-term opportunities thanks to continued expansion of its subscriber base. However, the synergies derived from the mobile business would be offset by intense inflationary pressure, stiff competition from its rivals, such as America Movil S.A.B. de C.V. (AMX - Analyst Report) and Telecom Italia S.P.A. (TI - Snapshot Report), and excessive government intervention.

Moreover, Telefonica Brasil will continue to suffer from tariff cuts. Brazil’s telecom regulator Anatel has cut both fixed-to-mobile and mobile-to-mobile tariffs by 10.78% to BRL0.48, effective from February 24, 2012. Similar reductions are expected in 2013 and 2014.

Further, Anatel expects that mobile interconnection fees would fall 80% by 2018 to BRL0.10. The drop in interconnection and network usage fees would significantly hurt revenues going forward. Besides, obtaining new licenses might be difficult in the competitive industry and would drag down revenues and profits.

Hence, we have a negative outlook on the stock. Telefonica Brasil also holds a Zacks #5 (Strong Sell) Rank for the short term (1–3 months).

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