Do the Huge Dividends of Windstream and Frontier Communications Interest You?

Source: Flickr user Chas Redmond.

Exchange-traded funds offer a convenient way to invest in sectors or niches that interest you. If you'd like to add some telecom companies to your portfolio but don't have the time or expertise to hand-pick a few, the Vanguard Telecom Services ETF could save you a lot of trouble. Instead of trying to figure out which stocks will perform best, you can use this exchange-traded fund to invest in lots of telecom companies simultaneously.

Why telecom, and why this ETF?
The telecom sector is huge -- telecom operators rang up about $2 trillion in revenue worldwide last year, and the industry has the potential to get even bigger. Consumers are demanding more and better connectivity, which means new technologies and new equipment are needed. The mobile realm in particular is growing briskly, with niches such as mobile payments and security showing particular promise, while smartphones are spreading like wildfire in emerging markets.

ETFs often sport lower expense ratios than their mutual fund cousins, and the Vanguard Telecom Services ETF has an exceptionally low one of 0.14%. It also recently yielded about 3.7%. It has outperformed the world market over the past five years but lagged it a bit over the past three.

A closer look at some components
On your own you might not have selected Windstream Holdings Inc or Frontier Communications Corp as telecom companies for your portfolio, but this ETF includes them among its 31 holdings.

With a dividend yield of 9.9%, Windstream draws a lot of interest, as does Frontier, with its 7% payout. Not all big dividends are worthy of your dollars, though, as some are tied to shaky companies. Both of these companies have their share of critics: More than 13% of Windstream's shares were sold short as of late May, while more than 16% of Frontier's shares were sold short. But Windstream's stock is up some 41% over the past year and has averaged gains of 14% over the past five. Frontier's five-year average is just 6.7%, but it's up more than 60% over the past year.

What's going on with these companies? Well, both are telecom companies that have focused on the rural market and landlines in the past. That's not a promising field as more people switch to wireless communications, so the companies are working hard to develop wireless offerings for consumers and businesses -- and their strategies are bearing some fruit.

Frontier's last earnings report featured record net broadband additions, with market share growing in 91% of markets. It's still losing customers, but at a slower rate due to retention efforts. The company bought AT&T's Connecticut operations last year, boosting its customer base and extending its geographical reach. Windstream, meanwhile, is offering data centers and cloud-computing services, with its chief executive officer noting in May that its last quarter was "our best quarter ever in terms of enterprise sales." Its free cash flow is growing, but so is its share count, which shrinks EPS -- and debt is growing, too.

There are risks with both companies. Their fat dividends, for example, may end up trimmed if business slows. And Frontier's last earnings report reflects just that -- a pullback in both residential and business revenue, along with shrinking profits and net margins. Both companies, especially Windstream, also carry significant debt, which can constrain them and threaten dividends.

On the other hand, successful strategy shifts don't happen overnight. There's reason to be hopeful about the prospects for both companies, but they do present more risk than many other alternatives. Of course, their dividends can offset some of that risk -- as long as they last. (Both companies sport worrisome payout ratios.) If you buy into either, you should keep a close eye on its progress.

The big picture
It makes sense to consider adding some telecom companies to your portfolio. You can do so easily via an ETF. Alternatively, you might simply investigate its holdings and then cherry-pick from among them after doing some research on your own.