A Dividend-Paying ETF In A Consolidating Industry

Aug.11.14 | About: Vanguard Telecom (VOX)

By Robert Goldsborough

Morningstar's Take
The United States telecommunications industry is in flux, from the top down. For quite some time, AT&T (NYSE:T) and Verizon (NYSE:VZ) had consolidated much of the telecom space, to the point that the sector more or less consisted of those two heavyweights, and then everyone else. Recently, however, a new round of consolidation has been taking place, driven by a desire for greater economies of scale, more telecom spectrum, and a bulwark against cable operators' incursions onto what historically has been telecom firms' turf. Deals in the past 24 months have included T-Mobile (NASDAQ:TMUS) buying MetroPCS, AT&T acquiring Leap Wireless, Sprint (NYSE:S) bringing Clearwire under direct control, and Verizon buying Vodafone's (NASDAQ:VOD) 45% stake in Verizon Wireless.

Most recently, the long-rumored pairing of Sprint and T-Mobile--which many observers had expected to be announced by the end of July 2014, despite likely antitrust challenges--turned out to be a mirage. French telecom Iliad SA recently made a surprise $15 billion offer for T-Mobile, which T-Mobile thus far has not accepted. In the wake of that offer, Sprint, which now is controlled by SoftBank and still operating in the red, abandoned its plans this week to pursue T-Mobile and also announced that it would replace its CEO and try to turn its business around.

For the most part, further mergers and acquisitions activity is a positive for the industry itself. For industry investors, however, we see consolidation as a mixed bag. AT&T and Verizon currently have industry-leading margins by a wide amount. As the players in the next tier consolidate and strengthen, it could be a modest negative for those two titans. At the same time, consolidation would help those smaller firms improve their cost structures and move up toward acceptable profitability over the long term.

All this recent industry upheaval obscures the basic fact that despite changes in technology and residential customers' secular shift from fixed-line telephone service to wireless service, the telecom industry is, somewhat paradoxically, a fairly mature industry. Much of the basic infrastructure needed for services already is in place, capital spending as a percentage of sales has declined meaningfully for many telecom carriers, and many firms now generate hefty cash flows and have used their excess cash to boost their dividends, make acquisitions, or even buy back shares. And some smaller firms that have had heavier debt loads have worked successfully to pay down their debt.

One reason some investors are drawn to telecom firms relates to dividends, as some large, best-in-class telecom firms have offered above-average dividend yields and have had the capital and cash-generating ability to meet their near-term obligations and maintain dividend payments. This fund's dividend yield and annual payout have displayed some volatility during the past decade. Some telecom firms, such as AT&T and Verizon and their predecessors, have had stable or rising dividends for decades. However, dividend payouts have been less consistent among some of the smaller players, owing mostly to high amounts of financial leverage. Big dividend cuts have occurred at firms such as CenturyLink (NYSE:CTL) and Frontier (NYSE:FTR), and Sprint outright eliminated its dividend a few years ago. We don't see the current round of M&A activity ultimately having a major impact on telecom companies' dividend payouts.

One suitable option for investors interested seeking relatively concentrated exposure to the U.S. telecom industry is Vanguard Telecom Services ETF (NYSEARCA:VOX), which is the largest U.S. telecom exchange-traded fund. VOX, which would work best as a tactical investment for the satellite portion of a portfolio, holds 30 U.S.-domiciled telecom companies, consisting of telecom service providers, one tower operator, and an IT services firm (inContact (NASDAQ:SAAS)). This fund is very top-heavy; the top 10 holdings account for 70% of the portfolio. Its top two holdings (AT&T and Verizon) make up 44% of the portfolio.

Although many large telecom firms are not especially volatile, this fund also holds telecom firms across all parts of the market-cap spectrum. In fact, large-cap telecoms make up 51.5% of this fund's assets, while mid-cap telecoms comprise another 15% of assets. Of the nearly 30% of VOX's assets that are devoted to small-cap companies, a clear majority (some 25% of the fund's total assets) is invested in micro-cap names. That has had the effect of making VOX more volatile than one might expect--and slightly more volatile than the typical large-cap fund. During the past five years, VOX has had a volatility of return of 14.3% compared with 13.4% for the S&P 500 and 16.2% for a competing iShares ETF.

VOX's dividend is 3.4%.

Portfolio Construction
VOX tracks the MSCI US Investable Market Telecommunication Services 25/50 Index, which contains both fixed-line and wireless telecom service provider stocks plus a pair of tower operators. (This fund does not hold cable operators.) Integrated telecom services operators represent 63% of the index; the remainder is devoted to wireless telecom service providers (18% of the index) and alternative carriers (18%). VOX's index weights its holdings by market cap, which results in very low turnover. The index also caps its largest holdings' weightings. Its top two holdings are not permitted to exceed 22.5% of the index each.

VOX's 0.14% expense ratio is less than one third the fee of the competing telecom ETF iShares US Telecommunications (NYSEARCA:IYZ). However, investors should note that IYZ is much more liquid than the Vanguard fund. VOX's performance has been good relative to its index, which indicates that this fund has done a very good job of tracking its index and that fund shareholders also have benefited from significant share lending. While investors shouldn't necessarily expect that to continue, it speaks to the fact that Vanguard is managing this fund in a very shareholder-friendly manner.

For similar broad-based domestic exposure to the telecom sector, investors could consider iShares US Telecommunications (IYZ) (0.43% expense ratio). IYZ charges much more than VOX.

Another critical aspect of the difference between IYZ and VOX relates to the weightings in AT&T and Verizon. Both the Dow Jones index that IYZ tracks and the MSCI index that VOX tracks cap the weightings of their largest constituents for diversification. However, the caps are much higher in the MSCI index, which is why AT&T and Verizon's weightings are so much higher in the Vanguard ETF. Those two companies make up between 13% and 14% each of IYZ's assets. The Vanguard fund's index, by contrast, follows a strategy of capping the individual weightings of the top two securities at a maximum of 22.5%. Because AT&T and Verizon's market caps are so much larger than the other companies in VOX, they routinely bump up against (and often temporarily exceed) that 22.5% cap in VOX. We note that IYZ's structure makes it slightly more of a mid-cap-oriented fund relative to VOX. As a result, IYZ is slightly more volatile.

A recently launched and very inexpensive option is Fidelity MSCI Telecommunication Services Index ETF (NYSEARCA:FCOM), which charges 0.12%. However, FCOM has minimal assets and is thinly traded. FCOM tracks a slightly different index from VOX; FCOM tracks the MSCI USA IMI Telecommunication Services 25/50 Index, while VOX tracks the MSCI US Investable Market Telecommunication Services 25/50 Index. Fidelity customers with a minimum balance of $2,500 can buy FCOM commission-free, although they are subject to a short-term trading fee by Fidelity.

Another option is SPDR S&P Telecom ETF (NYSEARCA:XTL), which is a modified equal-weight portfolio of 57 U.S.-based companies that make up a select industry index of the S&P Total Market Index. Unlike VOX, however, XTL also holds equipment makers such as Qualcomm (NASDAQ:QCOM) and JDS Uniphase (JDSU). XTL charges 0.35% but is thinly traded.

Those interested in gaining exposure to global telecom titans such as Vodafone and Telefonica (NYSE:TEF) should consider iShares Global Telecom (NYSEARCA:IXP) (0.48% expense ratio). Verizon comprises 16.5% of IXP's assets, and AT&T makes up another 14.5% of assets. Apart from U.S. companies, which make up about 34% of IXP's assets, IXP focuses most on developed foreign markets, with emerging-markets companies comprising about 10% of its assets. Investors may find appealing IXP's lower historical volatility than U.S.-only telecom ETFs.

In general, the major domestic telecom ETFs have highly correlated performance. VOX's performance has shown a 96% correlation to IYZ's performance during the past five years. However, VOX's performance has been less correlated (80%) to IXP's performance during the past five years.

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