Communication Services Sector Report

Sector report by Katarina Lau, 29 January 2021

S&P 500 Communication Services S5TELS

EXECUTIVE SUMMARY

The Communications Services sector is made up of companies whose main purpose is to help people connect with each other, mainly information technology companies and telecommunications companies. Tech companies often are internet providers that use software to help businesses and individuals stay connected. Similarly, telecoms companies are phone plan providers that use infrastructure to distribute information through television transmissions, broadband internet and mobile wireless, etc.

Interestingly, this sector was born out of a major shuffling by the Global Industry Classification Standard (GICS) which adapted to the evolving definition of communications amid the growing integration between telecommunications, media, and internet companies. As telecommunications services shrunk while information technology services grew, M&A across these industries which facilitated the bundling of cable, internet and telephone services and helped integrate distribution channels amongst streaming services, became more common than ever. Social media gradually became the most frequent medium of communication, allowing IT to take the lead in communication services, which eventually drove these sector changes.

In 2018, the GICS created a new, more encompassing sector known as Communication Services, which included major IT companies such as Facebook and Alphabet, Consumer Discretionary giants, like Netflix and Comcast and the entire Telecommunications sector which was mainly dominated by AT&T and Verizon. The reshuffling was also known as “de-FAANGing”, after the collective success of major tech giants Facebook, Apple, Amazon, Netflix and Google (FAANG) caused certain sectors to be unhealthily overweight in the S&P 500. As a result, all companies involved saw a boost in trading volume after the new sector change.

Therefore, the Communications Services sector recognizes how media, telecommunications and different Internet companies assimilate despite their overall differences. The shift from telecommunications services to communications services give communication ETFs more growth-oriented characteristics than ever before, as telecoms stocks are typically more defensive, however they also experience a decrease in dividend yield from about 5.5% percent to 1%.

OVERVIEW OF SECTOR

Sub-sector Industries:

The sector is split into “Telecommunications” and “Media and Entertainment” sub-sectors that together encompass a total of 5 industries.

Telecommunications

Diversified Telecommunication Services Industry

  • Includes Integrated Communication Services – operators of primarily fixed-line telecommunications networks, and companies providing both wireless and fixed-line communications services not classified elsewhere. Also entails Alternative Carriers – high-density data transmission services primarily through a high bandwidth/fibre-optic cable network.
  • Market Cap: $1.01T
  • Example Companies: AT&T Inc (T) [+2.20%], Verizon Communications Inc (VZ) [-3.17%]

Wireless Telecommunication Services Industry

  • Includes providers of primarily cellular or wireless telecommunication services and paging services.
  • Market Cap: $454.25B
  • Example Companies: Spok Holdings Inc (SPOK) [+2.36%], Telephone and Data Systems Inc (TDS) [+2.29%]

Media & Entertainment

Entertainment Industry

  • Includes movies and interactive home entertainment.
  • Market Cap: $1.29T
  • Example Companies: AMC Entertainment Holdings Inc (AMC) [+12.22%], World Wrestling Entertainment Inc (WWE) [+6.49%]

Interactive Media & Services Industry

  • Includes companies engaged in content/information creation or distribution through proprietary platforms, where revenues are mainly generated from pay-per-click advertisements. This entails search engines, social media and networking platforms, online classifieds, and online review companies.
  • Market Cap: $2.53T
  • Example Companies: Liberty TripAdvisor Holdings Inc (LTRPA) [4.99%], MediaAlpha Inc (MAX) [+13.91%]

Media Industry

  • Encompasses 4 existing Sub-Industries: Advertising, Broadcasting, Cable & Satellite, and Publishing.
  • Market Cap: $671.15B
  • Example Companies: ViacomCBS Inc (VIAC) [+8.82%], Fox Corp (FOX) [+8.87%]

As shown, it is hard to characterize communications stocks, as the sector contains a wide variety of both cyclical and defensive stocks. This makes the sector a decent hedge in both bullish and bearish markets. However, due to the higher weightage of IT companies, communications services are now better seen as a growth sector, which likely has higher potential for appreciation than the market overall. 

Recent Performance:

Over the last 12 months, the S&P Communication Services Select Sector index returned 23.22% YTD, in comparison to the S&P 500 returns of 14.4%. It’s difficult to describe this sector’s long-term performance, as the index was only created in September 2018. However, when S&P created the new index, it backtested it to 2007 and found that the sector returned 9.9% annualized in a span of 10 years, while the S&P 500 returned 7.25% in the same period.

FUNDAMENTAL QUALITATIVE SECTOR ANALYSIS

Investment Characteristics:

S&P’s Communication Services Sector has 26 constituents, where the top holdings include 3 FAANG stocks – Facebook (FB), Netflix (NFLX) and Google parent Alphabet (GOOGL), The Walt Disney Company (DIS) and telecoms giants AT&T and Verizon which previously made up 90% of the (now-integrated) telecoms sector.

Value-driven telecommunications companies typically pay bigger dividends, while growth-driven information technology companies lead in earnings growth. Both these features usually incentivize stock ownership. It is important to take note of capital expenditure for both types of companies: for telecoms, the amount invested in key infrastructure such as internet cables, satellites, and cell towers; for IT companies, the research and development (R&D) and content spending, to understand how companies are driving their future growth. Communications Services ETFs offer investors the same benefits as traditional exchange-traded funds, including low expense ratios, decent liquidity, and tax efficiency, as well as support selling short or buying on margin.

Advantages:

Growth and Investment Income

The presence of both growth and value companies in the sector favourably combine growth prospects of tech stocks with high dividend yields and relatively stable cash flows typical of defensive telecoms. (e.g. Verizon and AT&T historically pay rich dividends).

Highly Diversified

The sector’s diversity reduces company-specific risk and allows investment in an overlapping, but not unified groups of stocks.

Disadvantages:

FAANG Heavy

Despite the wide range of stocks, the small number of big market cap FAANG stocks may cause communications portfolios to attracts lofty valuations, leading to extreme volatility where even a minor event can trigger an aggressive sell-off.

Regulatory risk

This industry is subject to government regulation, which can affect performance. E.g. Changing privacy laws affects social media companies that utilise consumer data.

Lack of Differentiation

Some communications companies find it hard to stand out, because their services seem like commodities to customers. Among streaming services, lack of customer loyalty and the ease of switching providers led to a 41% churn rate for 1Q 2020.

Best Value Utilities Stocks:

Communications stocks with lowest 12-month trailing price P/E ratio – investors are paying less for each dollar of profit (or dividend) generated.

 Price ($)Market Cap ($B)12-Month Trailing P/E Ratio
Lumen Technologies Inc. (LUMN)10.7911.89.1
Nexstar Media Group Inc. (NXST)110.814.99.3
Telephone and Data Systems Inc. (TDS)18.982.29.9

Lumen Technologies Inc.: Formerly known as CenturyLink, offers various communications services, including local and long-distance voice, broadband, Ethernet, colocation, hosting, data integration, video, network and information technology. The company reported strong Q3 2020 results, where net income rose 21.2%, despite a 3.4% fall in revenue. Net income increased due to lower costs of services and products, depreciation and amortization charges, and interest expenses.

Nexstar Media Group Inc.: A television broadcast and digital media company, focused on greater expansion through the acquisition and operation of television stations, interactive community websites, and digital media services in medium-sized markets in the US. In December, one of its subsidiaries Nexstar Inc agreed to acquire consumer product recommendations company BestReviews Inc. from Tribune Publishing Co. for $160 million.

Telephone and Data Systems Inc.: A US-based diversified telecommunications company that operates in the cellular, local telephone, and personal communications areas.

Utilities Stocks with Highest Returns (Y-o-Y):

Price ($)Market Cap ($B)EPS Growth (%)
Zoom Video Communications Inc. (ZM)364.63104.36,500
IAC/InterActiveCorp. (IAC)196.5816.81,160
World Wrestling Entertainment Inc. (WWE)50.183.9850.0

Zoom Video Communications Inc.: Provides a video-first communication platform and Web conferencing services. Offers cloud-based HD video conferencing, mobility, and Web meetings.

InterActiveCorp. (IAC): A media holding company that provides media and Internet services. Subsidiaries include ANGI Homeservices, Vimeo, Search, Emerging & Other, Dotdash and Investopedia. In late December, IAC announced the company would spin off its full stake in Vimeo, making it an independent public company.

World Wrestling Entertainment Inc.: A media and entertainment company that offers live wrestling events, television programming, advertising, licensing etc.

 FUNDAMENTAL QUANTITATIVE ANALYSIS

Communications Services Sector (SRTS) vs. Benchmark Returns (S&P 500, Dow Jones, NASDAQ):

Pre-Covid, the Communications Services Sector (SRTS) grew at a faster pace than benchmark indices by almost 30% in less than a year from around $153 to $193. However, when the coronavirus pandemic was in full force by March 2020, the SRTS experienced the biggest decline to a record-low of about $138, a value lower than the sector’s starting value upon creation. Nonetheless, the SRTS has rapidly recovered all losses since by climbing to new highs around $228 in 2021. Hence, the above 2-year time frame shows that while the SRTS follows the same trends as benchmark indices during the economic cycles, Communications Services stocks are significantly more volatile.

Sector Fundamentals (as of 26/1/2020):

Market Cap$2.35T
P/E (2020 GAAP Actual)41.77
P/E (2021 Estimate)33.37
Enterprise Value$486.17B
EPS$13.82
EPS Growth-189.24%
Revenue Growth13.29%
Return on Equity8.81%
Return on Investment6.97%
Total Debt/Equity87.99
Dividend Yield3.76%

MACRO OUTLOOK

Effects of COVID-19:

Without a doubt, communications services became more important than ever since the pandemic. Lockdowns and movement restrictions forced the world to enter an era of remote interaction like WFH, and sped up the implementation virtual solutions to most, if not all previous social interaction. Therefore, communications technology of all kinds saw massive surges in usage, including cell phone service, video conferencing, gaming, and streaming services (e.g. Netflix added a record 37 million new subscribers in 2020) that enabled us to stay connected with each other. This is positive news for the sector as the new COVID-19 lifestyle has shown consumers how fundamental communications services are to everyday life, where services one might have viewed as complementary are now seen as a necessity. This translates into society’s more permanent reliance on communications companies, which will continue to drive economic development even after the pandemic. Looking ahead, 5G networks will revolutionize telecoms as well as pave way for future advancements like autonomous vehicles, smart cities, augmented and virtual reality etc. which certainly will tie in with IT companies.

Moreover, newly elected President Biden is yet to appoint 2 key positions in government that will play a pivotal role in regulating the Communications Services sector. First, is chair of the Federal Communications Commission (FCC), one of the most powerful U.S. government agencies, which regulates large corporations. Apparently, Biden’s pick is likely to promote “net neutrality” rules that make it harder for internet service providers to discriminate against content providers and influence legislation which prevents social-media sites from being held liable for content posted by their users. Second, is chair of the Federal Trade Commission (FTC), whose primary objective is to enforce antitrust laws that prevent monopolies from arising. Hence, Biden’s pick will also heavily influence the ongoing antitrust investigations into most FAANG companies.

KEY RISKS

Natural Disasters and Extreme Weather

As extreme weather events become increasingly common, communications infrastructure are at risk of damage and potential long-term outages (LTO).

Supply Chain and Global Political Vulnerabilities

Several communications companies rely on suppliers from all over the world, e.g. chipmakers in Taiwan, manufacturing in China, software in the US etc. This makes supply chains highly exposed to consequences of global unrest, economic sanctions and other factors that can easily affect distribution, foreign operations, employees etc.

Cyber Vulnerabilities

IT companies in particular are at risk of threats to their cyber ecosystem, be it from malicious hackers or system malfunctions which can have a network effect of compromising other suppliers, networks, and service providers.

PRICE TARGETS

ETF Price Targets:

Communication Services Select Sector SPDR Fund (XLC)

The fund holds 26 stocks in its basket and entirely replicates S&P’s Communication Services Select Sector index with Facebook occupying the top position at 21.2%. About 48.3% of the portfolio is allocated to interactive media & services, then followed by entertainment and media. It charges 13 bps in annual fees.

Previous CloseExpense Ratio
$67.910.13%
YTD ReturnVolume
0.55%6,700,026
1-Year ReturnNet Assets
26.91%$12.21B
Benchmark IndexYield
S&P Cmmncton Svces Select Sector TR USD0.67%
../../../Screenshot%202021-01-29%20at%209.41.46%20AM.png

Price Target: $70.00 (June 2021)

Before the pandemic hit, the XLC was at a record high of $57.58. It subsequently declined sharply to a low of $40.22 in March 2020, however since then it has been on a major rally reaching new highs of $67.91 over the past year. (On Jan 21, XLC reached an all-time high at $68.49). Given the existing upward trend and foreseeable advancements in information technology as well as pandemic-induced measures which boost communications technology usage, communications stocks are likely to continue going up, and by mid-year should hit $70 a share.

Vanguard Communication Services ETF (VOX)

The fund tracks the MSCI US Investable Market Communication Services 25/50 Index and holds 112 stocks in its basket. 45.8% of the portfolio is made of up of Interactive media & services, then followed by movies & entertainment, cable & satellite, and integrated telecommunication services. It charges 10 bps in annual fees.

Previous CloseExpense Ratio
$121.080.10%
YTD ReturnVolume
4.23%150,815
1-Year ReturnNet Assets
29.11%$3.3B
Benchmark IndexYield
MSCI US IMI/Comm Svc 25-50 GR USD0.74%
../../../Screenshot%202021-01-29%20at%209.40.46%20AM.png

Price Target: $125.00 (June 2021)

Similar reasoning as above. As the VOX also tracks Communications stocks and follows the same trend line as the XLC, it is likely to continue trending upwards after record-high performances in 2020. This is due to communications and technology services becoming increasingly present in consumer everyday lives. However, as the VOX is much more diversified, it will be less volatile, whereby it doesn’t surge or dip at one company’s news e.g. Netflix’s positive earnings or Facebook’s antitrust investigation. Therefore, by June next year, the ETF should have reached new highs of at least $125.

Leave a Reply

Your email address will not be published. Required fields are marked *