Author: Eric Uhlfelder

July 2011, Financial Advisor

Telecoms are the top-yielding securities, but caution is needed to realize meaningful total returns.

Since early 2009, when shares of the largest global mobile telecom service provider British-based Vodafone bottomed at $15.30, they have delivered total returns in excess of 90% in US dollar terms through late May. Investors in BCE, Canada’s largest telecommunications firm, have seen the value of their holdings more than doubled over the same period. And cumulative gains from Scandinavian telecom Telenor have tripled.

The case for telecom shares, explains Sergey Dluzhevskiy, associate portfolio manager of the $162 million GAMCO Global Telecommunications Fund, is that “they offer exposure to a sector that’s uniquely integral to the way people live and work. The wireless industry is still fragmented and should see further consolidation. And in emerging markets, wireless is very much a growth story.”

But the sector’s most compelling feature is its dividends. Telenor is currently paying 3.56%, Vodafone 4.67%, and BCE 4.85%. And these yields are on the modest side of the industry’s average.

According to the FTSE Global Equity Indices, the telecom sector has the highest dividend yield, currently paying 4.9%. That’s 20 basis points more than utilities. And yield of the fixed-line subsector is 6.1%. Some of the biggest names in this group are large-cap legacy service providers that had dominated the industry before deregulation opened up competition, and still hold leading positions.

Consistently high dividends bodes well for total returns, according to Daniel Peris, coportfolio manager of the $2.9 billion Federated Strategic Value Dividend Fund. The reason, he argues, is that “a company’s dividend distribution and the trajectory thereof are primary drivers of stock price over the long term.” Nearly 20% of his fund’s assets are in telecoms.

Many national and global telecoms trade on the New York Stock Exchange, with S&P credit ratings that average around “A-” [see table]. Average trailing PEs are around 10. And foreign shares offer exposure to currencies that further diversify portfolios and potentially boost total returns.

Despite their high yields, telecom shares are not stagnant investments and should not be thought of as savings proxies, CDs, or conservative bond-like plays. Trailing 52-week price ranges show a 50% gap between highs and lows. The S&P 500’s range was 33%. And many telecom shares, propelled by yield-hungry investors, have been steadily moving higher since the recession, with many currently trading at or near recent 12-month highs.

However, it doesn’t take much of a slide in prices to eliminate the dividend advantage. According to Morningstar, the total three-year annualized return of the iShares S&P Global Telecommunications Fund [IXP] is 0.01% through 1 June 2011, despite a current yield of around 3.9%.

Longer-term investment horizons may mitigate that risk. IXP has returned 6.65% annually over the past five years

The lessons: investors parking money in telecoms for several years or less may have their capital at risk; and even when going after yields, timing is pretty darn important to ensure total returns are worthwhile.

Daniel Martino, portfolio manager of the $2.2 billion T. Rowe Price Media and Telecommunications Fund has found that “not all yields are equal.” To mitigate risk, he urges investors to study the business mix to see where a telecom is generating cash flow and where it is not. “Understand valuation too,” Martino advises, “making sure you see how much you’re paying for the cash flow that supports the dividend.”

Unlike other industries where one can assess the safety of a dividend by looking at what percent of GAAP-stated earnings [earnings per share] it represents, Martino prefers looking at dividends as a percent of free cash flow. The reason, he explains, is that free cash flow, which nets out capital expenditures, then adds back depreciation–an accounting measure that can distort the true financial health of a company.

In all, he’d “rather own a company yielding 5% with a dividend-to-free-cash-flow ratio of 50% than a firm that’s paying 7.5% with a 95% payout ratio.” His fund’s long-term track record seems to support his point, with five-year annualized returns running 12.43%.

Investors can also reduce risk by establishing positions through dollar-cost averaging. Rather than jumping all at once into a telecom’s uber yields, investors should buy in tranches. Wait for an event to shake the market. They happen pretty regularly these days. When they do, add to your position.

Individual shares provide the most compelling and transparent way to gain telecom exposure and yield. They enable investors to discern specific corporate strategy, growth prospects, financials, dividends, demand for shares, and price movement.

A key lesson about telecoms: names often do not tell the entire story. Many telecoms’ geographic reach goes well beyond their original legacy coverage. For example, Telecom Italia [NYSE: TI]–the incumbent Italian phone company–generated sales of over €750 million in the first quarter of 2011 from its operations in Argentina, and over €1.6 billion from its operations in Brazil.

The purpose of such foreign ventures is to find more substantial growth than is available in mature home markets and to diversify revenue streams. There are little synergies in such ventures. But management expertise is exportable and historical cultural links, such as what exists between Italy and Argentina, can increase the chance that an acquisition can work.

To Judith Saryan, portfolio manager of the Eaton Vance Tax Advantaged Global Dividend Income Fund [ETG], expansion into a solidly growing region, improving management of a sizable debt load, low valuation, and a 6.2% yield that’s supported by a low payout ratio makes Telecom Italia a compelling investment. She established the fund’s 1.3% position in March as shares started recovering from a severe selloff.

Telefonica [NYSE: TEF], Spain’s incumbent service provider, is an even more geographically diversified play than Telecom Italia, with one-quarter of its 1Q2011 revenue derived from its European operations [ex Spain] and nearly half from Latin America. Overall, consolidated revenues were up nearly 11% from 1Q2010.

However, shares have been volatile. One reason: Telefonica represents 20% of the main Spanish equity index, the IBEX 35, which has suffered bouts of selling due to the country’s position in the eurozone debt crisis. Shares should eventually break free of this systemic drag as the market recognizes Telefonica as more of a global concern and focuses on the firm’s solid yield, which is currently 6.8% and supported by the firm’s commitment to dividend growth. According to T. Rowe Price’s analyst Chris Waterhouse, “Telefonica offers the best growth of all the major European incumbents at the same or lower P/E.”

After expanding across Scandinavia, incumbent Oslo-based service provider, Telenor [OTC: TELNY], turned its sights east, initially across Central Europe, the Balkans, and Russia, and then to Asia, including Thailand, Malaysia and India. According to UBS analyst Andy Parnis, three-quarters of 2011 projected revenue of 98 billion Norwegian krone [$18.2 billion] will come outside of Norway. He thinks Telenor has “an appealing mix of stable domestic positioning and fast-growing emerging market exposure,” and potential for a significant increase in cash returns. If the dividend is increased by 22% annually over the next three years, as the firm has suggested, this would significantly boost the company’s current yield of 3.56% and make this steady performing telecom even more attractive.

Investors may also receive a tailwind from a strengthening krone. With Norwegian public finances being among the healthiest of all develop markets, underpinned by huge oil reserves and exports, many currency analysts project the rally that has propelled the krone 22% against the dollar since the bottom of the recession to continue.

For many analysts, the world’s leading mobile service provider, London-based Vodafone [NYSE: VOD], is a compelling play because of its 45% ownership stake in Verizon Wireless. With this US mobile operator expected to generate $12.5 billion of distributable free cash flow in 2011, investors are anticipating a dividend to finally get paid on Vodafone’s position as of early next year. Payment should boost the value of Verizon Wireless and Vodafone.

Global turnover outside the UK, which accounted for nearly 90% of the firm’s £45.9 [$75.5] billion in revenues in Fiscal Year 2011, may also improve as customers continue to shift toward higher-fee smartphones. HSBC analysts Stephen Howard believes this will finally enable Vodafone to leverage its scale advantage.

With a current yield of 4.67% supported by a payout ratio of just 39%, Vodafone appears to be an attractive income play whose sheer scale [a market cap of over $145 billion] suggests a fairly stable ride.

Funds & Caveats
There are a number of open-ended mutual and exchange-traded funds that provide diverse exposure to telecoms. However, none fully exploit the yield advantage that investors can find in individual shares.

In a survey it prepared for this article, Morningstar found the highest yielding telecom fund is the SPDR ETF that tracks the S&P International Telecom Sector Index [IST]. Its current yield is 3.99%, followed by iShares S&P Global Telecommunications Sector Index [IXP], which yields 3.89%. Annual expenses of both are running around 50 basis points.

The SPDR ETF, which started up less than three years ago, delivered one-year return of 33.22%. The iShares global version was up 30.48%. And the latter’s 5-year annualized return was 6.65%. That topped the S&P 500 by 4.12% a year.

Among actively managed funds, ICON Telecommunications & Utilities S Shares offered the highest yields: 3.2%. But it comes with a hefty annual management fee of 1.67% and has only $23 million in assets. Over the past year, it was up nearly 25%. And its 5-year annualized rate of return of 4.32%

While communication services comprise only 40% of the portfolio, the $2.2 billion T. Rowe Price Media and Telecommunications Fund, makes the case that focusing on earnings growth rather than yield can deliver superior returns. Its dividend is a paltry 0.52%. But it generated total returns of 38% over the past year. And over the last five years, it’s been averaging returns of 12.43%.

GAMCO Global Telecommunications Fund makes the same case for capital appreciation. Started in 1993, it is the oldest pure sector fund around. Its yield is a modest 1.65%, basically matching its hefty annual expenses. However, the $162 million fund has delivered solid net annualized returns of 8.30% over the past 15 years, 1.82% a year better than the S&P 500.

Whether advisors assemble shares on their own or opt for funds, there are potholes to watch for.

It’s often tricky to get an absolute beat on foreign yields. They vary among various data sources. Best to check annual reports. Then there are often withholding taxes on dividends earned in many parts of the world. Across most of continental Europe, it’s 15%. Most of that, however, can get recouped through tax credits. Speak to your accountant about this.

Very high yields don’t necessarily translate to strong total returns. For example, Deutsche Telekom currently yields 6.59% and France Telecom 7.58%. Since the bottom of the bear market in March 2009, DT was up a cumulative 16%, FT has been flat, while the US broad market has doubled.

Australian Telstra has been an exception, with a yield of more than 8% and consistently solid performance, albeit one supported by a rallying Aussie dollar.

Dividends can go down as well as up, especially when a company is carrying too much debt, as was the case with Telecom Italia. After peaking in 2007 at $1.90 per US ADR share, its dividend subsequently fell to $0.61 in 2009 to help reduce its debt load.

On the supply side, deregulation has required legacy carriers to share their infrastructure and to finance upgrades that can benefit the competition, who piggyback onto these networks at rates that generate only marginal profits for their owners. Ever-shifting technology also means strong pressure on cap-ex as networks evolve from the latest generation of telephony to the next. And on the demand side, governments are recognizing that mobile customers are easy targets to tax, which could cut into usage.

The market was spooked on the first day of June when the World Health Organization ratcheted up concerns about the effects of long-term cellphone use, now classifying electromagnetic radiation as ‘possibly carcinogenic to humans.’ It does not quantify the risk, and suggests further research is necessary.

Telecom Sampling (PDF)


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