Global Telecom, a Compelling Combination of Dividends and International Growth

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 .

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.

All risks considered, we think IXP could offer a compelling investment opportunity. Ultimately, we believe that global demand for phone, television, and Internet connectivity will continue to expand. IXP's global exposure is a big positive, as investors can partake in emerging markets' rapid adoption of telecom services without assuming single-stock country risk. We'd also note that there is a fair mix of exposure to corporate clients among the fund's top holdings. In fact, revenues have shifted sharply toward data and Internet services and away from traditional voice. As businesses use networks to move more data around and drive basic business functions, demand for connectivity among offices and workers should continue to grow nicely.

Portfolio Construction
IXP seeks to replicate the performance of the S&P Global 1200 Telecommunication Sector Index--a subset of the S&P Global 1200 Index. Because the telecom sector contains a handful of behemoths, this market-capitalization-weighted index is extremely top-heavy. In fact, the top 10 holdings of this ETF soak up more than 69% of assets. Further, the top five holdings-- AT&T (T), Vodafone,  Verizon Communications (VZ), America Movil, and China Mobile--comprise almost 52% of assets. U.S. companies make up more than 35% of assets, with the United Kingdom, Japan, Mexico, Canada, China, Australia, and France next in line with weightings of approximately 14%, 8%, 6%, 6%, 5%, 4.5%, and 4%, respectively. More than 97% of assets are parked in large-cap stocks, with the remainder in mid-caps. The fund's average market cap, on a holdings-weighted basis, is about $68.5 billion.

IXP's portfolio contains 37 stocks.

Fees
IXP charges a net annual expense ratio of 0.48%. Cheaper alternatives do exist.

Alternatives
Investors seeking exposure to the telecom sector have several other options, but it's difficult to find any funds that do not have massive weightings in telecom behemoths like AT&T and Verizon. For those drawn to IXP for its international flavor, SPDR S&P International Telecom Sector  (0.50% expense ratio) might be a suitable alternative. Even though IST, which only holds telecom companies not based in the U.S., does not hold AT&T or Verizon, the ETF remains top-heavy, investing more than 63% of its assets in its top 10 holdings. While IST does not own the two big domestic heavyweights, Vodafone and Telefonica alone comprise more than 28% of IST's entire portfolio. Investors should take note, however, that IST is very small, with low trading volumes.

For broad-based U.S. exposure to the telecom sector, investors should consider   Vanguard Telecom Services ETF (VOX) (0.19% expense ratio),  iShares Dow Jones U.S. Telecom (IYZ) (0.47% expense ratio), or the recently launched, very inexpensive (but still very thinly traded)  Focus Morningstar Communication Services Index ETF  (0.19% expense ratio), which holds 31 firms. Investors should be aware that unlike the other funds, FCQ also holds cable companies like  Comcast (CMCSA) and  Time Warner Cable .

 

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Disclosure: Morningstar, Inc. licenses its indexes to institutions for the creation of ETFs and ETNs. Morningstar receives fees that are mainly based on fund assets under management. AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Scottrade, and Van Eck currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.