The Best Telecom Investments

Includes: IST, IXP, IYZ, S, T, VOX, VZ, XTL
by: Catalyst Investments

The citizens of earth can't live without their phones.

Mobile phones are as ubiquitous as automobiles. You can't go anywhere without seeing them in the hands of those around you. And yet, despite their saturation, there is still room for telecom sector growth in developing countries, the ever expanding economy of China, and in the smartphone market.

Within the next five years, global demand for data will skyrocket, as emerging markets continue to expand and the entire world continues to go mobile. Without a doubt, the money will follow; global revenue from mobile broadband is expected to grow 19% to between $123-$125 billion by 2016.

So Where's The Money?

Yet with the demand, carriers are mostly losing money, not making it. AT&T (NYSE:T) lost $3.9 billion in the fourth quarter of 2012 after losing $6.7 billion a year earlier. Verizon (NYSE:VZ) reported a $4.23 billion loss in the fourth quarter of 2012, while Sprint Nextel (NYSE:S) announced a $1.3 billion loss in its previous quarter.

Though these companies are taking part in the new technology based economy, they are suffering from old economy problems: pension shortfalls and infrastructure upgrades.

AT&T's fourth quarter was impacted by a $10 billion charge related to having to shore up its pension plan, while Verizon's pension liabilities cost it $7.2 billion for the quarter.

A series of press releases from AT&T demonstrates perhaps the biggest challenge of making money in the growing telecom sector. In separate announcements, the company boasts of making investments over the last two years of $60 million in Idaho, $700 million in Arkansas, $1.3 billion in Indiana, and $975 million in Mississippi. Those are just a few of the multi-million dollar investments AT&T has made with the goal of expanding its high-speed 4G LTE mobile network.

Yet, the return on those investments and on existing assets is paltry. Verizon's current return on assets is a meager 1.3%, while its return on investments is 3.7%. AT&T's ROA (1.7%) and ROI (2.8%) are similarly low.

That's because consumers strongly demand the enhanced services that technological upgrades provide. Carriers aren't investing huge amounts of capital on infrastructure upgrades to gain new customers so much as to keep their existing ones. And even with those upgrades, cutthroat competition keeps companies from charging a premium for the better products and services they can now provide.

What's more, the product life cycle in the industry is shrinking, meaning companies have little time to recoup their investments in upgrades. Further pressuring the bottom line is the need to bundle services in order to compete.

There Is Good News

But the news isn't all bad. One advantage the industry possesses is the high barrier to entry that should keep a cap on the number of competitors that existing carriers have to worry about. First, carriers need access to spectrum, which are the public airwaves that wireless providers broadcast from. Second, the deployment of fiber optic infrastructure requires abundant capital and expensive licenses from government entities. Thus, the U.S. market is essentially controlled by four national players: AT&T, Verizon Wireless, Sprint Nextel and T-Mobile USA.

Also, the increase in smartphones, tablet PCs, and e-readers have provided telecom companies with valuable data, which they mine with each download. According to analysts at Fidelity, since 2007 the average revenue per unit (ARPU) of data for the four largest U.S. carriers grew from $9.50 to almost $27. This has become the lifeblood of the industry and has been the major driver of wireless revenues over the last 10 years.

In addition to growth potential, the telecom industry's other appealing factor is the payment of dividends. AT&T's dividend currently yields more than 5%, while Verizon's is 4.6%. Those are small yields compared with CenturyLink's (NYSE:CTL) 7% yield.

Because of this dichotomy between growth potential and high capital expense, choosing individual winners in the telecom industry is a daunting task. Therefore, experts suggest investors who want to capitalize on this sector should consider an exchange-traded fund. ETFs are similar to mutual funds in that they hold a portfolio of investments and trade shares of their funds on the stock exchanges.

Examples of ETFs in the telecom sector include:

iShares Dow Jones U.S. Telecom ETF (IYZ)

This ETF has grown to $600 million assets since it launched in May 2000, making it the largest ETF fund in the telecom sector. It currently holds 28 stocks, with 62% of its holdings allocated to the top 10 firms in the industry. About 10% of its assets are in AT&T stock, with another 8% in Verizon Communications.

Criticisms of this fund include its relatively high expense ratio of 0.47% and the fact that two-thirds of its holdings are in traditional fixed-line telecom service providers.

IYZ has given investors a one-year return of 20.75% and a three-year return of 14.46% and currently yields 2.55%

iShares S&P Global Telecommunications Sector Index Fund (IXP)

Investors who want to diversify globally may want to opt for this fund. It has 38 large cap and value stocks representing companies in the U.S. (35% of its holdings), the United Kingdom (14%), Japan, Canada, Mexico, and many others.

The fund was launched in November 2011 and has $585 million under management. About 68% of its holdings are in the sector's top 10, with AT&T, Vodafone (NASDAQ:VOD) and Verizon accounting for nearly 39%. Its expense ratio also skews higher, currently at 0.48%

Its most recent one-year return is 12.61% while its three-year return is 10.32%. It currently yields 4.6%.

Vanguard Telecom Services ETF (VOX)

With an expense ratio of 0.19%, VOX is one of the lower-cost telecom ETFs. Started in September 2004, it holds 35 industry stocks and has assets totaling $530 million.

About 69% of its holdings are tied up in the top 10 carriers, with 43% combined in AT&T and Verizon.

It has a robust one-year return of 21.52% and a three-year return of 15% while currently yielding 3.42%.

SPDR S&P International Telecommunications Sector ETF (IST)

The key differences between this fund and IXP are size (IST has $24 million in assets compared with IXP's $585 million), its diversity (IST has 50 stocks compared with IXP's 38) and its concentration (IST is more heavily weighted in Europe while IXP in the U.S.)

The fund was started in July 2008. Nearly a fifth of its assets are allocated to Vodafone. Its current annual return is 9.15% while it has returned 6.76% over the last three years. Its current yield is 4.86%.

SPDR S&P Telecom ETF (XTL)

This ETF, launched in January 2011 with a current asset base of $4.5 million, has a much different focus than the previous listings.

It is far more diversified with no one single company accounting for more than 3% of its holdings. It also tends to invest more in small-cap stocks, and is more diversified by telecom sector, with allocations in communications equipment (56.7%), wireless services (21%), integrated services (13.8%), and application software (2.2%).

It has generated a return of 9.86% over the last year. Its expense ratio is 0.35%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by an analyst at Catalyst Investments.

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