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Global Telecom, a Compelling Combination of Dividends and International Growth

This sector-oriented ETF offers the best of both worlds for investors: income, low volatility, and exposure to fast-growing emerging markets.

Robert Goldsborough, 08/03/2012

Looking for exposure to rapid growth in the wireless telecommunications industry in emerging markets, while at the same time enjoying healthy levels of income and lower volatility? Consider iShares S&P Global Telecommunications IXP. This narrowly focused exchange-traded fund is an appropriate way to tap into an attractive mix of stable, mature, U.S.-based telecom firms, which make up about one third of this fund's assets, and overseas wireless and land-line providers, many of which have access to faster-growing emerging markets where phone penetration levels have long runways ahead.

With a dividend yield approaching 5% and a three-year beta of just 0.66, IXP offers stability at a time when many investors are concerned about equity market volatility. And it provides unique exposure as the only ETF to straddle the divide between U.S. and foreign-based telecoms. The fund tilts heavily toward the largest global telecoms, holding just 37 companies and devoting close to 70% of its assets to its top 10 holdings. However, many of IXP's holdings have meaningful operations in rapidly growing emerging markets, such as Vodafone VOD, America Movil AMX, and China Mobile CHL.

Suitability
Given IXP's narrow focus, investors should treat this exchange-traded fund as a tactical tool for the satellite portion of their portfolios. IXP is also suitable for investors searching for yield (with a yield of nearly 5%) and is suitable for investors desiring a globally tilted ETF as an alternative to domestic-only telecom funds. IXP is fairly concentrated; a few industry stalwarts soak up the bulk of its assets.

Outside the United States, most phone companies have continued to hold up fairly well as more customers adopt wireless and high-speed Internet-access services. Although growth suffered recently as customers cut back on wireless usage, most of the telecom carriers that Morningstar's equity analysts follow continue to generate significant free cash flows, which we expect will provide stability. Given the risks inherent in IXP's underlying holdings, an ETF is a good way to spread risks whenever telecom valuations are attractive. Also, IXP is anchored by industry-leading, cash-generating firms; the riskier firms here make up the portfolio's tail and as a result don't hold much sway.

Fundamental View
Since 2000, the telecommunications sector has matured in more ways than one, shifting from an industry with high leverage, weak profitability, and uncertain growth potential to one with solid free cash flows and steady dividends. A big part of the industry's maturing process has been the proliferation of wireless devices and Internet usage. Wireless phones and Internet access both are now viewed by almost everyone as necessities rather than as luxuries. More than 90% of Americans now have a wireless phone and 77% of Americans use the Internet. The phenomenon is by no means unique to the U.S., as wireless penetration rates (defined as SIM cards per person) in most of Europe are in the triple-digit range, and emerging-markets countries are fast closing the gap.

Further, high penetration rates don't necessarily suggest a low ceiling for growth. Demand for smartphones and mobile broadband still is rising. Globally, Morningstar's equity analysts estimate that smartphone sales will increase at a 30% clip for the next few years. Recurring telecom services revenue tied to these devices is likely to grow sharply over the next several years, as smartphone users are more likely to surf the Internet and use multimedia messaging services. We believe that the average revenue per customer, or ARPU, can continue to rise even if competition intensifies.

As wireless and Internet access services have grown, carriers have begun to reap the rewards of past heavy network spending. While telecom firms have continued to spend to add capacity, much of the basic infrastructure needed to provide services already is in place, and capital spending as a percentage of sales has declined for many firms around the world. As a result, telecom firms now generate hefty cash flows. Chastened by the telecom bust, firms with questionable finances have used cash to retire debt rather than make huge acquisitions or undertake major new projects. As balance sheets have improved, telecom dividends have become more sustainable and actually have increased in some cases. With juicy dividend yields and improved balance sheets throughout the sector, many telecom firms fit the profile of a traditional bear-market investment.

Because of the telecom industry's wide-scale shift from fixed-line to mobile services, the industry probably is less recession-resistant than it was in the past. After all, cash-strapped customers currently subscribing to bundled packages or both fixed and mobile telephone lines can elect to either discontinue their land lines or trade down to cheaper cable and Internet services. In the past, when these companies primarily were fixed-line operators, their customers had fewer communication options, so the likelihood of mass contract cancelations was far less. Also, outside the U.S., most wireless phone users still pay on a per-minute basis, and as people use their phones less (both as they migrate from voice to data and also from the economic slowdown), that hurts the overseas telecoms' ARPU.

Robert Goldsborough is an ETF Analyst at Morningstar.
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