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.
