Telecom at a Crossroads: What ETF Investors Need to Know

Given so much ongoing M&A activity, the telecom sector has been capturing a considerable amount of headlines lately. Below, a look at what is going on in the industry, and ways ETF investors can invest in telecom.

The U.S. telecommunications sector currently sits at something of a crossroads.

While the sector remains dominated by heavyweights AT&T (T) and Verizon Communications  (VZ), a raft of merger-and-acquisition activity is going on among the next-largest carriers in a process whose outcome is far from clear. Although most carriers have done a solid job managing and navigating the ongoing transition from voice service to data service, all players are grappling with how industry pricing will shake out, particularly in light of the ongoing consolidation activity. Positively, the telecom sector certainly is not the roll-up sector that it once was, and--with several notable exceptions--its participants aren't facing significant financial leverage. In fact, several players now pay significant dividends, and many have the flexibility to make the kinds of capital investments necessary to strengthen their networks.

For investors interested in broad exposure to the telecom sector as a whole, an exchange-traded fund can make a lot of sense. Large ETFs offer investors exposure not just to the twin titans in AT&T and Verizon but also to many of the smaller players that focus on specific regions or service offerings. And in an ETF, an investor can gain the best of both worlds--upside from the sector as the wireless side of the industry continues to grow and data service grows unabated, along with a fairly dependable income stream in the 2.5% to 3% range.

The Lay of the Land: Behemoths AT&T and Verizon, and the Next Level Below
AT&T and Verizon long have dominated the U.S. telecom industry by virtue of their size and their industry-leading margins. Both AT&T and Verizon's part-owned subsidiary, Verizon Wireless, have strong competitive positions in the wireless business. Both firms also are struggling with a fixed-line business that is in transition, as many customers are ditching their land lines but still are using their fixed lines for Internet access. AT&T has rebounded from a couple of setbacks, including its failed attempt to acquire  T-Mobile  (TMUS). It also has been relatively unscathed from the loss of its iPhone exclusivity, as customer defections have remained low. Verizon has done a solid job keeping Verizon Wireless' competitive position intact but also is seeing its fixed-line business under pressure from cable companies and an eroding customer base. Both firms have very loyal postpaid customer bases. And more broadly, both firms are navigating a very tricky transition. For both firms, voice provides the majority of wireless revenue, but industry competition and declining usage are pressuring that revenue stream. Data revenue continues to grow, but the firms are trying to figure out how best to find their "sweet spot" with tiered data-pricing plans. However, that tiered model is being challenged directly by several smaller competitors, such as Sprint Nextel  (S)  and T-Mobile  (TMUS).

Below AT&T and Verizon are firms such as Sprint Nextel, T-Mobile, and CenturyLink (CTL). In general, the firms' margins are lower, their balance sheets are more leveraged, and they have struggled to retain customers and improve profitability. As a result, those players generally tend to price slightly below AT&T and Verizon to offer what we would say is comparable service.

Everybody Wants More Spectrum
One of the biggest issues facing the U.S. telecom industry is its desire for more wireless spectrum to meet customer needs. Currently being debated in the halls of Congress is what the federal government's stance should be toward limiting AT&T and Verizon's access to spectrum in upcoming wireless spectrum auctions (likely in 2014 or 2015) in favor of smaller carriers, versus allowing the free market to determine the winners in future Federal Communications Commission spectrum auctions. The two behemoths actually have occasionally practiced a form of "coopetition" in recent years when it comes to spectrum. Most notably, AT&T spent nearly $2 billion in early 2013 to buy unused wireless airwaves from Verizon Wireless that Verizon Wireless previously had acquired from SpectrumCo. More broadly, ever since the failure of its bid to acquire T-Mobile, AT&T has been making smaller spectrum deals to boost its high-speed wireless network and catch up with Verizon Wireless, which is the dominant leader in next-generation spectrum.

Regardless of the timing of and any restrictions on future FCC auctions, the potential to acquire more wireless spectrum can offer upside to carriers as they seek to broaden their networks. And acquiring spectrum also is an obvious future use for carriers' free cash flows. While some investors might be concerned that increased spectrum investments could place pressure on telecom-services firms' abilities to pay steady dividends, we don't see upcoming spectrum buys as being so large or impactful that they would limit dividend payments. What's more, details regarding future spectrum auctions still remain very unclear. The timing is uncertain, and it's still not known just how much spectrum the current spectrum holders, television stations, will be willing to give up.

Ongoing M&A: What Does It Mean for Everyone?
Right now, several key merger-and-acquisition moves that have occurred recently or that are pending have grabbed headlines. The situation remains fluid as of this writing.T-Mobile recently closed on its acquisition of MetroPCS. Meanwhile, satellite TV subscription titan DISH Network(DISH) and Japanese mobile operator SoftBank have been battling to acquire Sprint Nextel. This has been occurring at the same time that Dish and Sprint have dueling bids to acquire Clearwire (CLWR). (Sprint currently is the majority investor in Clearwire and is hoping to bring the company under full control.) It's still not clear to us how that situation will resolve itself. On top of all of this, Verizon long has wanted to buy the 45% of Verizon Wireless that currently is owned by Vodafone(VOD).

In general, the smaller players' margins trail those of AT&T and Verizon by a considerable amount. However, further consolidation of some of those players could be a positive for the smaller operators (assuming no merger integration mishaps), as they would end up with an improved cost structure and better long-term profitability. What's more, AT&T and Verizon have done a solid job up to now at expanding their share at the expense of those players. By contrast, a stronger Sprint or T-Mobile would be a modest negative for AT&T and Verizon as those smaller players no longer would be sources of easy market share gains. 

Ultimately, the industry's ongoing merger-and-acquisition activity may well be neutral for investors in the sector as a whole. What's clear to us is that how the industry responds to consolidation, with regard to pricing, will have more to do with the sector's broad success. If the participants are able to find and stick to a rational pricing structure, investors in the industry as a whole should benefit. Although irrational pricing is always a risk, we don't anticipate any changes to the industry's pricing dynamics.

Dividends, Dividends, Dividends
For any investor interested in the telecom sector, dividends have to be part of the story. And dividends across the telecom sector have varied considerably. AT&T and Verizon historically have paid high and relatively stable dividends (with yields currently between 4% and 5%). The smaller firms' payouts have been more varied, as some firms with high debt levels have had to cut dividends (such as CenturyLink and Frontier Communications  (FTR)). And Sprint, with its very high leverage, actually cut its dividend altogether several years ago. Despite some smaller, leveraged players, the industry's aggregate, weighted dividend payouts have been reasonably constant in recent periods, and we would expect that to remain the case going forward, anchored by AT&T's and Verizon's stable payments.

ETFs Devoted to the Telecom Industry
There are two large ETFs focused on the U.S. telecommunications industry. Our pick is Vanguard Telecom Services ETF (VOX), which charges a very low 0.14% expense ratio. VOX holds 34 U.S.-domiciled telecom companies, with a portfolio tilted almost entirely toward telecom-service providers. The fund has very large weightings in AT&T and Verizon (each account for more than 20% of the portfolio), even after its index places a 22.5% cap on each of the firms' index weights, in order to allow for diversification in the index. The fund offers slightly lower volatility than the market as a whole and pays around a 3% coupon. VOX also holds some smaller telecom-service players with a more regional or startup focus.

The other large telecom ETF is iShares Dow Jones US Telecom (IYZ). It's a much more expensive ETF than VOX (charging 0.46%), but owing to the way its index is constructed, the weights in AT&T and Verizon are much less (each make up between 8.5% and 9% of the fund, owing to index-imposed caps on individual securities for diversification purposes). That means that IYZ is far more of a small- and mid-cap-tilted fund, with a correspondingly slightly higher level of volatility. IYZ holds 25 companies.

Over the years, the two ETFs have performed mostly as one might expect, with IYZ largely performing better in bull markets and VOX generally doing better in more volatile markets. Since 2008, VOX's dividends have risen, but IYZ's dividends actually have fallen, reflecting the greater stability found in VOX by virtue of the greater weightings in AT&T and Verizon. IYZ, by contrast, was more affected by some moves by smaller carriers, including Sprint's elimination of its dividend in 2008, Frontier Communications' drastic dividend cuts in 2010 and 2012, and CenturyLink's dividend cut in 2013.

A global telecom ETF option is iShares S&P Global Telecommunications (IXP), which charges 0.48% and devotes 65% of its assets to companies based outside of the United States. The demand drivers for the foreign-domiciled companies held in a global telecom ETF are not significantly different from those driving firms held in a U.S.-only telecom fund because both kinds of funds have relatively comparable exposures to the telecom sector's faster-growing wireless segment. Part of the appeal for IXP is the fact that it has had lower historical volatility and a meaningfully higher dividend yield than U.S.-only telecom ETFs. At the same time, we would highlight that IXP devotes about one third of its assets to telecom firms based in Europe, which generally carry more debt (and have been paying down that debt) but which also have been undergoing considerable spending on their networks, causing some carriers to cut their dividends.