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1 Automation and robotics Chief Investment Office WM 17 February 2016 Alexander Stiehler, CFA, analyst, Sundeep Gantori, CFA, CAIA, analyst, We still believe that smart automation will power the fourth industrial revolution, combining the innovation of industrial and IT processes to drive global manufacturing productivity gains. Despite an uncertain near-term macro environment, the longterm growth prospects for the smart automation industry are intact. Longer term, we expect mid-to-high single-digit rates on average. Due to lower investments from commodity-related sectors, however, we expect the industry to post only low single-digit growth rates in the short term. Rising wages and challenging demographic developments will pressure costs of manufacturing companies in emerging markets, driving automation investments. We see the most potential in the software and robotics (factory Source: UBS database automation) sub-sectors. Both should post low, double-digit, shortterm growth rates. The near-term outlook for process automation is less promising due to falling investments from oil and gas, and petrochemical customers. House View The manufacturing industry has a history of being able to re-invent itself. Whether in the first industrial revolution of steam-generated power, or the next revolution supported by electric power, industry found ways to boost productivity. Another industry revolution is underway, that we believe will transform the future of manufacturing. It is powered by smart automation (SA) as Industry 4.0 rises in importance. SA combines the innovation power of industrial and IT processes to drive gains in global manufacturing productivity. This report discusses recent trends and the outlook for factory and process automation, industrial software and 3D printing, as well as including a section about commercial drones. Although the global manufacturing sector is currently struggling due to falling capital expenditures mainly in the oil and gas and mining sectors, we believe that automation is one of few niches that can outperform due to structural trends like demographic changes, rising labor costs in emerging markets, the drive for productivity gains, and rising IT penetration. In particular, the industrial software and robotics segments offer high growth opportunities. At the recent World Economic Form in Davos, automation market leader Siemens mentioned its intent to double its number of software engineers by This underpins the importance of industrial software over the next decade. We see two positives in this theme: 1) long-term, above-average earnings growth, and 2) re-rating potential for industrial companies with automation software exposure. Both should lead to superior performance compared to the broader equity market in the years to come. This is an excerpt from a UBS CIO WM publication. For access to the complete research report, please visit the UBS Quotes online portal or contact your client advisor for assistance. This report has been prepared by UBS Switzerland AG and UBS AG. Please see important disclaimers and disclosures at the end of the document.

2 Growth drivers The World Bank estimates that global manufacturing revenues are roughly USD 15trn today. Despite growth in recent years, we believe SA is still in its early stages. Based on our market definition, automation only has a 1% share of the manufacturing industry's total global revenues (USD 146bn). If our assumption is correct that automation revenues will clearly outperform normal manufacturing revenues, the share could almost double to 2% over the next 10 years. Fig. 1: Elderly population in G7 countries Total % of population, To understand the potential of the automation theme, it is important to identify the secular trends that could lead to strong growth in the next few years. We have identified several drivers that should stimulate sustainable growth over coming business cycles: We anticipate that the penetration rate will approach 2% over the next 10 years, based on our assumption that average revenue growth in the SA industry will be in the mid-to-high single digits. From an investment perspective, SA represents one of the fastest growing segments within the broader industrial and IT sectors during the next decade. Canada Germany France Japan UK US Itlay Source: OECD as of January 2016 Fig. 2: Factory (discrete) versus process automation We think emerging markets (EM) are one of the most promising growth themes. In EM, robotics usage is still far behind developed countries, but an aging population in developed and EM (demographic challenge), the need to drive productivity gains, rising wages and the size of the manufacturing sector make it an attractive region for automation equipment (see Fig. 1). Particularly in China, the mass reallocation of cheap labor from the agricultural sector to manufacturing is coming to an end. Urbanization is currently slowing from 20 million per annum to million at present. We expect that the rising IT penetration in the manufacturing sector (industrial software) can lead to a new wave of automation investments in developed countries. Compared to other industries like office automation or healthcare, the use of software or IT penetration is still lower in the manufacturing automation world, but we are now reaching an inflection point, with software moving down to the factory floor, accelerating automation within manufacturing. Source: CLSA When people think about automation, most picture an industrial robot assembling a car. In reality, that is only one part of the entire automation value chain, which can broadly be split into two categories: factory and process automation. Industrial software is becoming an increasingly important business driver in both segments. Factory (or discrete) automation generally describes assembling processes, such as our robot in the automotive industry, but also other automation processes in the general manufacturing industry, packaging and semiconductors, to mention the most important ones. Process automation means continuous production processes that transform raw materials into final products (e.g. mixing of liquids in refining, or distribution of electricity). Typical process automation end-markets are the oil and gas industry, refining, chemicals or power generation. Between these two sectors are several hybrid markets that use both factory automation and process equipment. Fig. 2 summarizes all different automation end markets. 2

3 Discrete and process automation are important industry end markets for industrial automation companies. UBS estimates that the combined value is USD 115.3bn, 43% attributable to process automation and 57% to discrete automation. If we include the emerging 3D printing market and revenues from pure-play automation software companies, then the total market volume amounts to some USD 146bn. The definition of the market size can vary from source to source. In our analysis, we used a bottom-up approach and aggregated automation sales of the most important market participants. Fig. 3: Robot density manufacturing industry by country, 2014 Robots per 10,000 employees In the following four sections we cover the most important industry drivers and investment opportunities around the automation theme: factory automation, process automation, industrial software, and 3D printing. Factory automation The largest end market in the factory automation market is the automotive industry; typical products are programmable logical controllers (PLCs), electric motors, sensors, robots and, of course, manufacturing software. The highly consolidated market is controlled by European and Japanese vendors, with four players controlling nearly half of the market. On average, the discrete automation market grew 3.3% p.a. between 2006 and Robot shipments outperformed during this period (9% CAGR in the last decade), due to strong demand in EM and in particular China. In the short term, the Chinese manufacturing sector is struggling, which is not supportive of the sentiment for factory automation stocks. For the overall discrete automation segment, we expect growth of 1% p.a. in the next two years and again higher growth afterwards. In our view, the robotics sub-segment is still very exciting. Despite this subdued short-term outlook, the segment will still be the main growth engine. For , the International Robotics Federation (IFR)expects at least 15% growth on average per year. Asia/Australia are expected to grow on average by 18% p.a. and the Americas and Europe by around 10% p.a. On top of the software revolution, we see several additional drivers that should spur sustainable growth in the coming years. EM account for roughly half of global manufacturing output. However, robot penetration is much lower than in developed countries. Despite the strong growth over recent years in China, the potential is still huge. In terms of robot density, China appears to be at a level comparable to Japan in the 1970s and Korea in the late 1980s and early 1990s. There is still a 60% gap compared to the global average and up to 90% compared to South Korea or Japan (see Fig. 4). Source: IFR World Robotics, as of September 2015 Fig. 4: Newly installed robots in 2018 versus % 90% 80% 70% 60% 50% 40% 60,000 41,559 40,000 24,721 40,000 29, ,000 57,096 30% 20% 10% 45,559 66,000 31,029 44, F 0% North America Europe China Japan South Korea Other Source: IFR World Robotics, as of September 2015 The International Robotics Federation expects that by 2018, 150,000 robots will be installed in China alone (total installation globally in 2014: 229,261), representing a global market share of 38% (total installation in 2018: 400,000). Other strong markets are Europe and North America (see Fig. 5). In the early 2000s, when EM companies first started investing in automation equipment, the underlying trend was toward better quality (machines are more precise than human beings) and first attempts to increase productivity. Today, we see two additional trends for automation demand: 1) rising labor costs, and 2) labor shortage (an aging and better-educated population). Since 2000, wages in China have risen significantly above other markets (see Fig. 6), and China's one-child policy triggered a decline in new labor supply and advanced the shift toward an aging population. While not every 3

4 EM country is aging, with India as a case in point, the manufacturing-led economies like China, Korea and Taiwan clearly are. On top of this, rising levels of education have resulted in a fewer workers willing to take lowerpay manufacturing jobs. Whereas the demographic challenge is a longterm topic, rising labor costs are an important short-term driver, as higher wages shorten the payback period for robots. Aside from the costs, efficiency is also much higher with robots; the best example is the automotive industry. The numbers are impressive, but comparison with other countries reveals China's early stage of development. In 2011, Japanese automotive manufacturers used circa 130 robots and 750 workers to produce 10,000 cars per year, compared to 20 robots in China and 1,700 workers. India is even worse, with less than 10 robots and roughly 2,000 workers. Both examples show intuitively that rising wage costs and labor shortages should lead to rising automation demand. Fig. 5: Relative unit labor costs (indexed to 100 in the year 2000) China Brazil 175 The market for robots is very consolidated; only four companies control a major part of the global market and three-quarters of robots were sold in just five countries/regions in 2015 (China, North Amercia (US, Mexico, Canada), Japan, Korea, and Germany). Process automation As mentioned earlier, process automation involves a continuous flow of raw materials (e.g. in the oil and gas or chemicals industries), where a high degree of measurement, timing and precision is important. The automation part is a kind of central computer that interacts with valves and sensors to run the process smoothly. 125 Germany 75 US Japan US Japan China 2010 Brazil Germany Source: Haver, UBS Without process automation systems, plant operators have to physically follow all parameters during the production process and afterwards assess the quality of the output. In addition, maintenance is not performed when necessary, but rather during regular intervals. Therefore, without automation equipment it is much harder for plant operators to achieve best performance compared to an automated plant that has sensors and computers to analyze thousands of signals. Inefficiency in production processes and sub-optimal maintenance intervals make operations more costly. Similar to factory automation, this market is also fairly consolidated. Nine companies have a combined market share of 74%. The growth rate has been on average 4% p.a. since 2006, driven by a strong investment cycle in the chemical and oil and gas markets. The shale gas revolution in the US has triggered a wave of investments in both sectors, supporting process automation. Since our first report in autumn 2014, the market conditions for process automation deteriorated. The oil price collapsed since then, negatively impacting process automation capital expenditures (capex). As a result process automation demand also suffered, declining by around 4.6% in We expect in the short term ( ) a declining market trend by 2% p.a. and trend growth afterwards. Industrial software The growth outlook for industrial software remains solid as more companies leverage the benefits of digitalization in product manufacturing. The rising trend is more apparent as many manufacturing companies began to 4

5 carve separate internal teams called a "Digital Factory" to take advantage of software in manufacturing. Despite a mixed outlook for overall enterprise IT spending, the outlook for the software industry remains solid with mid-to-high, single-digit growth in industrial software, which constitutes around 85% of the broader software industry, expected to post aboveaverage growth. The two major sub-industries within the industrial software segment include product life cycle management (PLM) and manufacturing execution systems (MES). PLM is generally considered an enterprise level software system, whereas MES is a plant level system, the major difference being that PLM is used in development and corresponding production processes, while MES is used to optimize the production process. An example of PLM is a computer aided design (CAD) software program for designing products on the computer; an example of MES is operation management software. Increasingly, some IT services companies have begun investing more in the industrial software and services area to take advantage of the industry's strong growth outlook. A survey done by PwC further supports our strong outlook for the industrial software segment. Based on PwC's survey of Germany's industrial companies, only one-fifth of the survey participants have digitized industrial processes along their value chain, with 80% of them planning to digitize within the next five years. In the process, an average 18% increase in efficiency is expected both in terms of better productivity and resource efficiency. A Cap Gemini study shows digitization boosts operating profits by 5-30% as manufacturing competitiveness rises. The key drivers behind the growth of industrial software remain 1. Solving design complexity: Industrial software helps manufacturing firms reduce design complexity, which in most cases is considered a key bottleneck. For example, Renault's Formula One team leverages industrial software by using state-of-the-art simulation technologies for a broad range of applications including engine combustion, intake and exhaust, thermal cooling, batteries, electric motors, and turbochargers, thus enhancing its race competitiveness. Despite rising usage, we still expect significant growth potential for design-based software, particularly from EM, given the low penetration. 2. Improved time to market: By solving design complexity and improving production efficiency through integrated tools, industrial software can significantly improve the time to market. A recent McKinsey study shows that digitization will reduce the time to market by 30-50%. In this regard, in addition to the advancement in 3D printing or additive manufacturing, drones are fast emerging as a key IT tool for the growth of industrial automation. 5

6 Fig. 6: Overview of the industrial software market Level of control Enterprise Resource Planning (ERP) Plant design and simulation / Digital Factory Enterprise level Product Life Cy cle Management (PLM, including CAD) Manufacturing Ex ecution Sy stems (MES) Superv isory Control and Data Analy tics (SCADA) Process Industries Hybrid Industries Discrete Industries Additive Manufacturing Plant level Distributed Control Sy stems (DCS) Programmable Logic Controller (PLC, PAC) Safety Sy stems Motion control Production Sy stems Machine Tools CNC Robots 3D Printers Device level Measurement dev icesactuation dev ices Valv es Pumps Driv es -- Motors -- Gears Compressors Metrology (3D inspection, measurement calibration) Source: J.P. Morgan Implications for industrial companies Today, industrial software only accounts for roughly 5-15% of automation sales for most capital goods companies with significant market share. However, the strong growth that we expect in this segment could make the difference through the next cycles. As already mentioned, we expect 10% annual growth in the industrial software segment over the next years. The resulting impact on automation companies at a group level is additional growth of around 1-2% on top of the normal hardware growth (throughcycle roughly 4%). Another point worth highlighting in this context is the higher operating margin level for industrial software sales. In 2015, average automation margins were between 14% to 16% vs. industrial software margins north of 20%. One recently acquired software business achieved a 63% gross margin and 24% net margin in FY Taken together, higher growth combined with better margins in the software divisions could have a strong positive impact on valuations too. Pure-play companies in the software sector trade at a 40% premium to "normal" hardware automation stocks. To better understand the opportunity, let's do a quick calculation using two theoretical examples: company A has a growing industrial software part and company B is only focused on hardware (see Fig. 10). All characteristics being equal (cost of capital, leverage and asset intensity), automation company A has a slightly higher margin than company B (15% vs. 14%) due to better software margins and higher sales growth (5% vs. 4%). The result is impressive, the multiples are much higher, company A trades at an 18% P/E premium to company B and has an implied higher equity value of 27%. This example shows the positive earnings and margin impact of software growth and the resulting re-rating potential for automation companies. We think that this opportunity is not yet reflected in share prices, and investors have the opportunity to benefit from this trend over the next few years. Fig. 7: Example of impact on value depending on growth Company A Company B Sales Sales growth 5% 4% EBIT margin 15% 14% Debt Interest 3% 3% Tax rate 30% 30% 10.1% 9.4% NWC / sales 10% 10% Fixed assets/sales 20% 20% Long term growth 5% 4% 2.50% 2.50% Equity risk premium 6% 6% Beta 1% 1% 9.70% 9.70% Net income NWC Capex-depreciation = Free cash flow Value of equity (Gordon Growth) EV EV/sales 2x 1.6x EV/EBIT 13.5x 11.7x P/E 18.1x 15.3x Net income margin Risk free rate Cost of equity Source: J.P. Morgan, UBS NWC: Net Working Capital Remark: The Gordon Growth model is based on the assumption that the value of a company is worth the sum of all its discounted dividend payments. In this example, the value of equity is the discounted sum of free cash flows. 6

7 New long-term trends Rising demand for drones 3D printing remains a long-term opportunity Despite the recent mixed performance of 3D printing companies, we maintain our view that 3D printing holds promise only in the long term. Beyond a few current applications, any dramatic benefits are only expected in the longer term. In the near term, rather than being applied to mass production, we see opportunities for 3D printers in businesses requiring rapid prototyping and high customization with small production quantities in the near future. Wohlers Associates, a leading industry research firm on 3D printing, expects the industry's revenues to grow from around USD 7.3bn in 2016 to USD 21.2 bn in The rise of commercial drones Drones, which were initially restricted to military use, slowly entered into personal use and are now literally taking off for commercial purposes. Also known as unmanned aerial vehicle (UAV), drones are operated remotely or autonomously and generally carry a video camera to monitor flight. Although drones are still in their early days, they are being used across industries like manufacturing, utilities, agriculture, films and government organizations at a fraction of the cost of a manned aircraft. E-commerce and logistics companies are also beginning to experiment with drone technology, with Amazon, the global e-commerce leader, anticipating a future in which unmanned aircraft will exceed general air traffic, which today totals 85,000 flights a day. Source: istock Thanks to its autonomous features, drones could be a new tool of industrial automation. For industrial companies, drones could prove handy for aerial inspection surveying particularly in the oil, gas and mineral exploration and production industries, or for short cargo transport within the factory line, saving significant costs. Agriculture is another promising industry where drones can be widely used, e.g. to survey crops and spot irrigation problems. Despite the advantages of the drone market, we believe safety and other regulatory issues need to be sorted out before we can actually size the industry growth. Currently, many governments across the world are in the process of setting up regulations related to safety and privacy. At the moment, we think the estimates of the market research firm WinterGreen are reasonable; these forecast that global sales of commercial drones will approach USD 5bn in

8 Conclusion We think that over the next decade, the current industrial revolution will turn today's manufacturing into smart factories. In our view, the smart automation industry's total annual revenues currently stand at slightly below USD 150bn. Despite the recent weakness, we believe SA is one of the major growth segments in the industrials world, given that the industry's revenues are only 1% of the total global manufacturing industry's revenues. We believe that over the cycle the sector could grow by mid-to-high single digits, with industrial software and robots the clear outperformers. We expect that hardware companies with sizable software exposure should grow their automation business in the mid-single-digit area and pure-play software companies in the high-single to low-double-digit area. Overall, we think that industrial software will be a growing differentiator for companies and investors. We expect the industrial software market to grow on average at around 10% with superior margins. Software is at the center of this revolution, but there is also tremendous demand for automation hardware, such as robots, from EM and several sectors which should lead to sustainable growth. To mention one obvious example, the rising trend of multiple IT devices per individual (compared to one PC in the past) coupled with shorter product cycles (six-months to one year) is leading to a surge in device manufacturing coupled with increasing complexity. Against this backdrop, the rising trend of automation by IT manufacturers is evidence of the recent strong demand for industrial robots. Other supporting longterm drivers are demographic challenges in key countries like China and, in general, rising wages in EM. Box: Link to sustainable investing We think that Automation & robotics is part of the Energy Efficiency thematic, which is a sustainability-themed investment. Energy efficient products and services help significantly to mitigate climate change through the reduction of greenhouse gas emissions. Energy demand continues rising, particularly in emerging markets. A growing population, continued urbanization and rising wealth levels contribute to this structural trend. The most important driver for energy efficiency is stricter regulation. As a result, energy efficiency is becoming a key business factor for a growing number of companies that also affects consumers. From an investment perspective, smart automation represents one of the fastest growing segments in the broader industrial and IT sectors. To provide an overview of companies that benefit from this trend, we have compiled a reference list with 30 names in Fig. 11. Please note that this list is only for reference and is not a recommendation list. Investment conclusion From 2005 to 2015, automation companies achieved a median annual EPS growth of 15.8% p.a. compared to the MSCI World of only 6.3% (based on our reference list). For the next three years ( ), the market consensus expects an EPS growth rate of 10% p.a. for the automation stocks. In summary, we see two positives in this theme: 1) strong earnings growth and 2) re-rating potential for industrial companies with automation software exposure (see our example calculation in Fig. 9). We think investors have the opportunity to benefit from the automation and robotics trend over the next few years. Risks In the longer term, we see a global industrial recession as the main risk that would negatively impact automation investments. In the short term, a subdued oil price could hinder petrochemical investments in process automation, and peaking automotive investments could negatively impact factory automation spending. 8

9 Appendix Terms and Abbreviations Term / Abbreviation Description / Definition Term / Abbreviation Description / Definition A CAGR COM EPS p.a. UP actual i.e. 2010A Compound annual growth rate Common shares Earnings per share Per annum (per year) Underperform: The stock is expected to underperform the sector benchmark bn Capex E FY Shares o/s CIO Billion Capital expenditures expected i.e. 2011E Fiscal year / financial year Shares outstanding UBS WM Chief Investment Office 9

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