Sector Focus: Telecom ETFs Look Compellingly Valued

As exchange-traded fund investors survey the battered U.S. equity landscape in search of sectors with solid potential upside, we believe they should take a close look at telecommunications industry ETFs, which right now offer a tantalizing combination of strong dividends, attractive valuations, and large helpings of companies with economic moats.

While there is a moderate amount of uncertainty in the industry (the U.S. Department of Justice currently is suing to block AT&T's T planned acquisition of Deutsche Telekom's DTEGY T-Mobile USA unit, which effectively has placed the entire telecom industry in a holding pattern), for the most part, the telecom sector has developed into a mature industry. Gone are high leverage, weak profitability, and uncertain growth potential. In their places are cash-generating machines such as AT&T and Verizon VZ that long ago rolled up much of their industry and built out much of the basic infrastructure necessary to support services today, along with tower companies and small wireless carriers. As the major carriers' legacy land-line businesses have gone away, the industry has shifted to focusing heavily on the proliferation of wireless devices and Internet usage in society. And growth looks promising for major carriers, with demand for smartphones and mobile broadband still rising at an impressive clip.

The Lay of the Land
The industry landscape right now consists of the two big industry behemoths--AT&T and Verizon. The following are also included:

• Some mid-cap players such as CenturyLink CTL, Windstream WIN, and Frontier FTR
• A set of smaller wireless carriers such as MetroPCS PCS, Leap Wireless LEAP, and Clearwire CLWR
• Tower companies such as American Tower AMT, Crown Castle CCI, and SBA Communications SBAC
• Special cases such as Sprint Nextel S, and Level 3 LVLT

In the medium term, Morningstar's equity analysts hold the view that smaller players in the industry, such as Sprint, Leap Wireless, and MetroPCS, need to join forces and gain financial flexibility to invest in next-generation network technology. Such next-generation technology is crucial to be able to add network capacity to keep pace with AT&T and Verizon. And if AT&T's acquisition of T-Mobile ultimately is killed, our analysts expect another operator to pick up T-Mobile.

Most recently, several telecom firms have posted weak earnings, and the sector as a whole has lagged the broader market during 2011. The sector clearly is out of favor, with likely few catalysts imminent until the T-Mobile issue is resolved.

Using an ETF to Invest in a Basket of Telecom Firms
Investors who have seen the market's recent pullback (and, particularly, its recent punishment of telecom firms) but want to avoid single-stock risk, should consider a telecom ETF. Currently, three ETFs focus solely on U.S. telecom firms. All three trade significantly below Morningstar's fair value estimates for the funds, which are calculated by aggregating and weighting our equity analysts' estimates of fair values for the ETFs' underlying constituents.

However, there are important differences among three ETFs that investors should be aware of before investing. Here are the details on the three funds: