investments. Longer Term Investments Source: Monty …

Longer Term InvestmentsAutomation and robotics

Chief Investment Office WM | 2 March 2018Alexander Stiehler, CFA, Analyst, [email protected]; Sundeep Gantori, CFA, CAIA, Analyst, [email protected]

• We believe smart automation will power the fourth industrialrevolution, combining the innovation in industrial and ITprocesses to drive global manufacturing productivity gains.

• As key automation end-markets bottomed last year and aregrowing again, we have raised our growth outlook for theautomation market for the next three years. We believecyclical and structural drivers support our theme.

• We expect mid-to-high single-digit growth rates onaverage in the longer term. Rising wages and challengingdemographic changes will pressure costs of manufacturingfirms, driving automation investments. Also, the increasingdigitalization of automation equipment is a key driverof higher efficiency and therefore more automationinvestments.

• We suggest long-term investors add positions in thisinvestment theme as key end-markets are nearing aninflection point after several years of below-average growth.

House viewThe manufacturing industry has a history of being able to re-inventitself. Whether in the first industrial revolution of steam-generatedpower, or the next revolution supported by electric power, industryhas found ways to boost productivity. Another industry revolutionis now underway, which we believe will transform the future ofmanufacturing. It is powered by smart automation (SA) as Industry4.0 rises in importance. SA combines the innovation power ofindustrial and IT processes to drive gains in global manufacturingproductivity. Industrial software raises automation equipment tothe next level from purely improving efficiency and accuracy.Automation is increasingly a tool for total operations and assetmanagement.

This report discusses recent trends and the outlook for factory andprocess automation, industrial software and 3D printing, as wellas commercial drones and artificial intelligence (AI). After severalweak years of low investments, the global manufacturing sectorrecovered last year and we are confident that the outlook for thecoming years is also promising.

We believe automation companies can further outperform therecovery due to structural trends like demographic changes, risinglabor costs in emerging markets, the drive for productivity gains,and rising digitalization. In particular, the industrial software androbotics segments offer high growth opportunities.

This is an excerpt from a UBS CIO WMpublication. For access to the completeresearch report, please visit the UBSQuotes online portal or contact your clientadvisor for assistance.

Source: Monty Rakusen, Plainpicture

LTIPopulation

growthAgeing

Urbanization

Int roduct ion to the Longer TermInvestments (LTI) series

The Longer Term Investments (LTI)series contains thematic investment ideasbased on long term structural develop-ments.

Secular trends such as population growth,ageing, and increased urbanization createa variety of longer term investmentopportunities.

Investors willing to invest over multiplebusiness cycles can benefit from potentialmispricings created by the typically shorterterm focus of stock markets.

This report has been prepared by UBS Switzerland AG and UBS AG. Please see important disclaimers and disclosures at the end of the document.

These changes should lead to: 1) long-term, above-averageearnings growth; and 2) re-rating potential for industrial companieswith automation software exposure. Both should result in superiorperformance compared to the broader equity market in the yearsto come.

Growth drivers

Based on our market definition, the automation market currentlyhas a size of USD 177.5bn (see Fig. 3). Driven by several structuraldrivers (which we will discuss in detail in this report), we expect theSA industry's average revenue to grow in the mid-to-high singledigits. From an investment perspective, SA will likely be one ofthe fastest growing segments within the broader industrial and ITsectors over the next decade.

To understand the potential of the automation theme, it isimportant to identify secular trends that could lead to strong, sus-tainable growth in the next few years:

• We think emerging markets (EMs) are one of the mostpromising growth themes. In EMs, robotics usage is still farbehind developed countries, but due to an aging populationnot only in developed countries (see Fig. 1), but also in EMs,the need to drive productivity gains, rising wages and the sizeof the manufacturing sector make it an attractive region forautomation equipment. This is true particularly in China, wherethe mass reallocation of cheap labor from the agricultural sectorto manufacturing is slowing.

• We expect the rising digitalization of the manufacturing sector(industrial software) to lead to a new wave of automationinvestments in developed countries. Compared to industrieslike office automation or healthcare, the use of software orIT penetration is still lower in the manufacturing automationworld, but we have reached an inflection point, with softwaremoving down to the factory floor, accelerating automationwithin manufacturing.

• In the past, new capacity expansion used to be the key driverfor demand; but now, industry upgrade has become moreimportant and will continue to be the predominant driver.

• In the future, industrial software (smarter equipment) willincreasingly also be a tool for asset optimization (remote mon-itoring, predictive maintenance).

• The so-called Industrial Internet of Things (IIoT) enables com-munication along the entire value chain, improving productivitythrough the use of big data (see also our investment theme"Riding the wave of Internet of Things").

When people think about automation, most picture an industrialrobot assembling a car. In reality, that is only one part of theentire automation value chain, which can broadly be split intoseveral categories, with the most prominent ones being factoryand process automation. Industrial software is becoming an increas-ingly important business driver in both segments. Factory (or dis-crete) automation generally describes assembling processes, suchas our robot in the automotive industry, but also other automationprocesses in the general manufacturing industry, packaging and

Fig. 1: Relative share of elderly people (aged65 and over) growing in every countryworldwideTotal % of population, 1955 – 2050E

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Fig. 2: Factory (discrete) vs. processautomation

Source: CLSA

Longer Term Investments

UBS CIO WM 2 March 2018 2

semiconductors, to mention the most important ones. Processautomation means continuous production processes that transformraw materials into final products (e.g. mixing of liquids in refining, ordistribution of electricity). Typical process automation end-marketsare the oil and gas industry, refining, chemicals or power gener-ation. Between these two sectors are several hybrid markets thatuse both factory automation and process equipment. Fig. 2 sum-marizes all the different automation end-markets. Besides the tra-ditional discrete and process automation market as well as thegrowing industrial software, we also count several new applicationsto the automation market like 3D printing, artificial intelligence anddrones (see Fig. 3). Although the new markets are still relativelysmall compared to discrete and process automation, they clearlyoutperform the growth in the overall automation market (unfortu-nately, there are only a few and they are small listed pure-play com-panies).

We discuss all end-markets in more detail in this report. Our focusin the first section will be on the discrete and process automationindustry as both end-markets are still most important for industrialautomation companies. UBS estimates that the combined value isUSD 124bn (2017E), with 44% attributable to process automationand 56% to discrete automation. If we include the emerging 3Dprinting market, artificial intelligence and drones plus revenues frompure-play automation software companies, then the total marketvolume amounts to some USD 177.5bn (see Fig. 3). To estimatethe market size, we have used a bottom-up approach and aggre-gated automation sales of the most important market participants.Compared to our last estimate (January 2017), we have raised ourgrowth forecast for the automation market due to three reasons:better growth in process automation (the market bottomed lastyear); continued growth in discrete automation, particularly dueto strong demand from China; and higher estimates in the dronesegment.



Fig. 3: Industrial software and new trends like 3D printing, artificial intelligence or drones drive industry growth

Source: Company data, UBS estimates, as of January 2018

Note: Our industrial software estimate includes only sales from software companies. Software sales from industrialcompanies like Siemens, ABB, Schneider Electric, etc. are included in either factory or process automation market dueto limited access to detailed sales splits of industrial automation companies.



Factory (discrete) automation

The largest end-market in the factory automation market is theautomotive industry; typical products are programmable logicalcontrollers (PLCs), electric motors, sensors, robots and, of course,manufacturing software. The highly consolidated market is mainlycontrolled by European and Japanese companies and a few USvendors, with five players controlling more than half of the market(Siemens, ABB, Schneider Electric, Rockwell Automation, and Mit-subishi Electric; see Fig. 4).

On average, the classic discrete automation market (ex-software)grew 3-4% p.a. between 2010 and 2017. Robot shipments outper-formed during this period (16% CAGR since 2010) due to strongdemand in EMs, particularly in China. After a weaker period forautomation equipment in 2015 and 2016, the global manufac-turing sector improved again in 2017. We expect mid-single digitannual growth rates in the next three years for the overall discreteautomation segment, slightly higher than historical growth levels.

We think the robotics sub-segment is still very exciting. The segmentwill still be the main growth engine. For 2018-2020, the Interna-tional Federation of Robotics (IFR) expects 15% growth on averagea year. Asia and Australia are expected to grow on average by15% p.a., the Americas also by 15% p.a. and Europe by slightlyless. On top of the software revolution, we see several additionaldrivers that should spur sustainable growth in the coming years.EMs account for roughly half of the global manufacturing output.However, robot penetration is much lower than in developed coun-tries. Despite strong growth over recent years in China and otherEMs, the potential is remains significant. In terms of robot density,China appears to be at a level comparable to Japan in the 1980s(see Fig. 5). There is still a gap compared to the global average,and nearly 90% compared to South Korea, the country with thehighest robot density (see Fig. 6). Despite strong progress in the US- 189 robots per 10,000 employees in 2016 compared to 114 in2009 - the country is still far behind Germany and Japan (both >300robots). This shows the huge potential globally.

The IFR expects 210,000 robots to be installed in China alone by2020 (total installation globally in 2017: 346,800), representing aglobal market share of 40% (expected total installation in 2020:520,900). Other important markets are the US, Korea, Japan,Germany, Taiwan, Mexico, Italy and gradually also India (see Fig. 7).

In the past, new capacity expansion used to be the key driver fordemand, but now industry upgrade has become and will continueto be the predominant driver. Automation equipment is increas-ingly also used outside of the automotive industry, which providesa growth opportunity for automation equipment manufacturers. Inparticular, industry upgrades in the low-to-mid-end manufacturingsectors drive demand (rising labor costs, labor shortage, and anaging and better-educated population that doesn't want to workin factories).

Fig. 4: Factory (discrete) automation marketshareTotal USD 70bn in 2017E


Fig. 5: Robot density in manufacturingindustry by country, 2016Robots per 10,000 employees

Source: IFR World Robotics (World Robotics Industrial Robots 2017)

Fig. 6: Robot density in manufacturingindustry (all industries) by country/region,2016Robots per 10,000 employees

Source: IFR World Robotics (World Robotics Industrial Robots 2017)



Since 2000, wages in China have risen significantly above othermarkets (see Fig. 8), and China's one-child policy triggered a declinein new labor supply and advanced the shift towards an aging pop-ulation. While not every EM country is aging, with India as a casein point, the manufacturing-led economies like China, Korea andTaiwan clearly are. On top of this, rising education levels haveresulted in a fewer workers willing to take lower-pay manufacturingjobs.

While the demographic challenge is a long-term issue, rising laborcosts are an important short-term driver as higher wages shortenthe payback period for robots. Other than the costs, efficiency isalso much higher with robots; the best example is the automotiveindustry.

The market for robots is very concentrated; just four companies(Fanuc, ABB, Yaskawa and Kuka) control a major part of the globalmarket and more than three-quarters of robots were sold in justfive countries in 2017 (China, South Korea, Japan, the US andGermany).

Process automation

As mentioned earlier, process automation involves a continuousflow of raw materials (e.g. in the oil and gas or the chemical indus-tries), where a high degree of measurement, timing and precision isimportant. The automation part is a kind of central computer thatinteracts with valves and sensors to run the process smoothly.

Without process automation systems, plant operators have to phys-ically follow all parameters during the production process and after-wards assess the quality of the output. In addition, maintenanceis not performed when necessary, but rather at regular intervals.Therefore, without automation equipment, it is much harder forplant operators to achieve best performance compared to an auto-mated plant that has sensors and computers to analyze thousandsof signals. Inefficiency in production processes and sub-optimalmaintenance intervals make operations more costly.

Similar to factory automation, this market is also fairly consoli-dated (see Fig. 9). Six companies have a combined market shareof 78% (Siemens, Emerson, ABB, Yokogawa, Honeywell, and Sch-neider Electric).

The annual growth rate was on average 4% from 2006 to 2015,driven by a strong investment cycle in the chemical and the oil andgas markets. The shale gas revolution in the US has triggered a waveof investments in both sectors, supporting process automation.

In 2015 and 2016, market conditions for process automation dete-riorated significantly. The oil price collapse hurt process automationcapital expenditures (capex). After bottoming in 2017, we expectgrowth till 2020, and similar to factory automation we expect mid-single digit annual growth off a lower base.

Fig. 7: China dominates global robot demandExpected newly installed robots in 2017 vs. 2020

Note: Others = reported and estimated sales which could not be specifiedby countriesSource: IFR World Robotics (World Robotics Industrial Robots 2017)

Fig. 8: Relative unit labor costs (indexed to100 in the year 2000)

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Fig. 9: Process automation market shareTotal USD 54bn in 2017E




Industrial software

The growth outlook for industrial software remains solid as morecompanies leverage the benefits of digitalization in product man-ufacturing. The rising trend is more apparent as many manufac-turing companies have started to carve separate internal teamscalled "digital factories" to take advantage of software in manufac-turing. Despite a mixed outlook for overall enterprise IT spending,the outlook for the software industry remains solid with mid-to-highsingle-digit growth in industrial software, which constitutes around85% of the broader software industry.

The two major sub-industries within the industrial softwaresegment include product life-cycle management (PLM) and manu-facturing execution systems (MES) (see Fig. 10). PLM is generallyconsidered an enterprise level software system, whereas MES is aplant level system, the major difference being that PLM is used indevelopment and corresponding production processes, while MESis used to optimize the production process. An example of PLMis a computer aided design (CAD) software program for designingproducts on the computer; an example of MES is operation man-agement software. Key vendors in PLM include Dassault, Autodesk,PTC and Siemens; the top vendors in MES include Invensys, CDCSoftware and Aspen (see Fig. 10). Increasingly, IT service companieslike IBM and Accenture have begun investing more in the industrialsoftware and services to take advantage of the industry's stronggrowth outlook (see Fig. 11).

Growth in industrial software will continue to depend on:1. Solving design complexity: Industrial software helps manufac-

turing firms reduce design complexity, which is often a key bot-tleneck. For example, Renault's Formula One team leveragesindustrial software by using state-of-the-art simulation tech-nologies for a broad range of applications including enginecombustion, intake and exhaust, thermal cooling, batteries,electric motors, and turbochargers, thus enhancing its racecompetitiveness. Despite rising usage, we still expect signif-icant growth potential for design-based software, particularlyfrom EMs, given the low penetration.

2. Improved time-to-market: By solving design complexity andimproving production efficiency through integrated tools,industrial software can significantly improve the time-to-market. In this regard, in addition to the advancement in 3Dprinting or additive manufacturing, drones are fast emergingas a key IT tool for the growth of industrial automation.

Fig. 10: Industrial software landscape

PLM=Product Life-cycle ManagementMES=Manufacturing Execution SystemSource: Company reports, UBS



Table 1: Overview of industrial software marketLevel of cont rol

Process Industries Hybrid Indust ries Discrete Industries Addit ive Manufacturing

Safety Systems Motion control CNC

Machine Tools Robots 3D Printers

Measurement devices Actuation devices Valves Pumps Drives -- Motors -- Gears Compressors

Distributed Control Systems (DCS)

Programmable Logic Controller (PLC, PAC)

Production Systems

Enterprise level

Plant level

Device level

Enterprise Resource Planning (ERP)

Plant design and simulation / Digital Factory

Product Life Cycle Management (PLM, incuding CAD)

Manufacturing Execution Systems (MES)

Supervisory Control and Data Analytics (SCADA)

Metrology (3D inspection, measurement callibration)

Source: J.P. Morgan

Implications for industrial companiesToday, industrial software accounts for up to one-third ofautomation sales for the companies we have highlighted inthis report; software accounts for an estimated low-singledigit of Fanuc's automation sales, mid-single digit for RockwellAutomation, low-double digit for Schneider Electric and ABB, andone-third for Siemens. However, the strong growth that we expectin this segment could make the difference over the next few cycles.Siemens, for instance, wants to double its number of software engi-neers by 2023 without making an acquisition (Source: Siemens). Asmentioned earlier, we expect 8-10% annual growth in the indus-trial software segment over the next few years. The resulting impacton automation companies at a group level is additional growth ofaround 1-2ppt on top of the normal hardware growth (through-cycle roughly 4%).

Another point worth highlighting in this context is the higher oper-ating margin level for industrial software sales. In 2016, averageautomation margins were 14-16% versus industrial softwaremargins of more than 20%. Mentor Graphics' business, acquiredby Siemens, achieved an 83% gross margin and a 15% oper-ating margin in FY15. Taken together, higher growth combinedwith better margins in the software division could have a strongpositive impact on valuations too. Fig. 12 shows the margin andgrowth differences of the most important European capital goodsand software companies over the last 17 years. Pure-play com-panies in the software sector trade at a 40% premium to "normal"hardware automation stocks.

To better understand the opportunity, let's do a quick calculationusing two theoretical companies: Company A has a growing indus-trial software part and Company B is only focused on hardware (seeTable 2). Assuming all other characteristics are the same (cost ofcapital, leverage and asset intensity), automation Company A has

Table 2: Example of impact on valuedepending on growth

Company A Company B

Sales 100 100

Sales growth 5% 4%

EBIT margin 15% 14%

Debt 20 20

Interest 3% 3%

Tax rate 30% 30%

Net income margin 10.1% 9.4%

NWC / sales 10% 10%

Fixed assets/sales 20% 20%

Long term growth 5% 4%

Risk free rate 2.50% 2.50%

Equity risk premium 6% 6%

Beta 1% 1%

Cost of equity 9.70% 9.70%

Net income 10.1 9.4

NWC 0.5 0.4

Capex-depreciation 1.0 0.8

Free cash flow 8.6 8.2

Value of equity (Gordon Growth) 183 144

EV 203 164

EV/sales 2x 1.6x

EV/EBIT 13.5x 11.7x

P/E 18.1x 15.3x

Note: NWC = Net Working Capital; EV = Enterprise ValueSource: J.P. Morgan, UBS

Remark: The Gordon Growth Model is basedon the assumption that the value of a companyis worth the sum of all its discounted dividendpayments. In this example, the value of equityis the discounted sum of free cash flows.



a slightly higher margin than Company B (15% vs. 14%) due tobetter software margins and higher sales growth (5% vs. 4%).

The result is impressive, the multiples are much higher - CompanyA trades at an 18% P/E premium to Company B and has an higherimplied equity value of 27%. This example shows the positiveearnings and margin impact of software growth and the resultingre-rating potential for automation companies. We think that thisopportunity is not yet reflected in share prices, and investors havethe opportunity to benefit from this trend over the next few years.

Fig. 11: Software - growth opportunities & margin potentialOver the last 17 years, software sales grew 2x and the margin is more than 2x higher than in the capital goods sector (forcomparison reasons, we used only European companies in both sectors) .

Note: rhs = right hand sideSource: Company data, Morgan Stanley, UBS, as of January 2018



New long-term trends

Artificial intelligence is at the center of the fourth industrialrevolutionArtificial intelligence (AI), which we refer to as a set of tools andprograms that makes software smarter in such a way that an outsideobserver thinks the output is generated by a human, is set to be asignificant driver in the automation space as it will have far-reachingimplications on many industries. In the most simplistic terms, AIleverages self-learning systems by using multiple tools like datamining, pattern recognition and natural language processing. Itoperates as a human would when conducting routine tasks suchas common-sense reasoning, forming an opinion or social behavior.That said, AI is an umbrella term to cover a confluence of mul-tiple technologies, such as machine learning, which includes deeplearning, cognitive computing, natural language processing, neuralnetworks, etc. (see Fig. 13).

The main business advantages of AI over human intelligence areits high scalability, resulting in significant cost savings. Other ben-efits include AI's consistency and rule-based programs, which even-tually reduce errors (both omission and commission), AI's longevitycoupled with continuous improvements and its ability to documentprocesses.

We believe AI can be divided broadly into three stages (see Fig.14): artificial narrow intelligence (ANI), artificial general intelligence(AGI) and artificial super intelligence (ASI). The use cases of AI aremanifold as AI-based software will push the limits of automation.Like a brain, AI powers the traditional sources of automation androbotics and drives progress of sectors like autonomous vehicles anddrones. But as a standalone industry, AI-based software can createsignificant business opportunities. Some examples include virtualassistants or chatbots providing expert assistance, smart or robotadvisors in the fields of finance, insurance, legal, media and jour-nalism, and expert healthcare systems that provide medical diag-nosis and assistance. Other benefits include significantly improvingefficiencies in R&D projects by reducing time-to-market, optimizingtransport and supply chain networks, and improving governance bybetter decision-making processes.

We are optimistic about the growth prospects of the AI industry. Theexponential growth in computing power and the solid cloud andsmart device ecosystem that are in place, coupled with favorablesupply factors like low computing and storage costs, advancedalgorithms and the increased availability of AI-based talent, aresupportive factors. On the demand side, we believe corporationsand governments are realizing the benefits of AI, resulting inincreased attention and spending on AI projects. We expect AI-related software revenues to rise from USD 5bn in 2015 to USD12.5bn by 2020, growing at an average 20% a year. While theestimate looks very conservative, the size represents only the third-party AI software market, with significant spending both on infra-structure and on internal projects. As the industry matures, weshould get a better idea on the overall size of the market. Fur-thermore, third-party software market growth rates should accel-

Fig. 12: Artificial intelligence is an umbrellaterm for many technologies

ArtificialIntelligence

Neuralnetworks

MachineLearning

NaturalLanguageProcessing

CognitiveComputing

Source: UBS

Fig. 13: Development of artificial intelligence

Source: UBS

Fig. 14: 3D printer- from bytes to bits

Source: Solidoodle



erate after 2020 as AI enters the second AGI stage, reaching a sweetspot with use cases and addressable market expanding sharply.

3D printing remains a long-term opportunityDespite the recent mixed performance of 3D printing companies,we think that 3D printing holds promise in the long term. Beyonda few current applications, any dramatic benefits are only expectedin the longer term. In the near term, rather than being applied tomass production, we see opportunities for 3D printers in businessesrequiring rapid prototyping and high customization with small pro-duction quantities. Wohlers Associates, a leading industry researchfirm in 3D printing, expects the industry's revenues to grow fromaround USD 9.6bn in 2017 to USD 21.2bn in 2020.

The rise of commercial dronesDrones, which were initially restricted to military use, slowlyexpanded to personal use and are now literally taking off for com-mercial purposes. Also known as unmanned aerial vehicles (UAVs),drones are operated remotely or autonomously and generally carrya video camera to monitor flight. Although drones are still intheir infancy, they are being used across industries like manufac-turing, utilities, agriculture, movie and government organizations ata fraction of the cost of a manned aircraft.

E-commerce and logistics companies are also beginning to exper-iment with drone technology, with Amazon, the global e-com-merce leader, anticipating a future in which unmanned aircraft willexceed general air traffic, which currently totals 85,000 flights a day.Thanks to its autonomous features, drones could be a new tool ofindustrial automation. For industrial companies, drones could provehandy for aerial inspection surveying, particularly in the oil, gas andmineral exploration and production industries, or for short cargotransport within the factory line, saving significant costs. Agricultureis another promising industry where drones can be widely used -for e.g. to survey crops and spot irrigation problems. The globaldrone market, according to Gartner and Bloomberg Intelligence, isexpected to grow from USD 6.1bn in 2017 to USD 11.2bn by 2020,with an average annual growth of 22%. The growth will not only bedriven by consumer drones but also commercial drones as demandcontinues to be strong across industries.

Despite the advantages of the drone market, we believe safetyand other regulatory issues need to be addressed before we canestimate the industry's growth rate. Many governments across theworld are in the process of setting up regulations on safety andprivacy.

Strong earnings growthFrom 2005 to 2017E, our automation and robotics theme achieveda median annual EPS growth of 16.8% p.a. (based on our equallyweighted reference list, which is at the end of the report), wellabove MSCI World's 6.7%. For the next two years (2018-2019), themarket consensus expects an EPS growth rate of 13.5% p.a. for ourtheme versus 10.3% p.a. for the MSCI World index (see Fig. 17).

Fig. 15: Rising demand for drones (revenuesin USD bn)

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Fig. 16: Historically, EPS growth has beenseveral percentage points higher than MSCIWorldAnnual EPS growth in %

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Automation theme MSCI World

Average Automation theme Average MSCI World

Source: FactSet, UBS, as of 29 January 2018Note: For the automation and robotics theme, we used the medianannual EPS growth (historical and projected) of the companies of thecurrent reference list as an indication for the theme since the year 2000.



Link to sustainable investing

We think that automation & robotics is part of the "energy effi-ciency" theme, which is a sustainability-themed investment. Energyefficient products and services help to significantly mitigate climatechange through the reduction of greenhouse gas emissions. Energydemand continues to rise, particularly in emerging markets. Agrowing population, continued urbanization and rising wealthlevels contribute to this structural trend. Energy efficiency gainsthrough more automation can help to alleviate scarcity in envi-ronmental resources. Given the relatively large size of the globalmanufacturing sector, an aging population and rising wages, thereis potential for a sustained expansion in automation equipment.As a result, automation is becoming a key business factor for agrowing number of companies. From an investment perspective,smart automation is one of the fastest growing segments in thebroader industrial and IT sectors.

Along with the question whether automation and robotics are asustainable investment (SI) investment theme, we investigate theSI profile of our reference list, which can be found at the end ofthis report. Fig. 18 illustrates the environmental, social and gover-nance (ESG) profile of our list, based on MSCI ESG Research ratingsthat rank companies between AAA (best) and CCC (worst), takinginto account various ESG factors. The assessment encompasses thethree ESG pillars. Each pillar has sub-categories: in the case ofthe environment, they are climate change, natural resources, pol-lution and waste, and environmental opportunities; in the socialsphere, human capital, product liability, stakeholder opposition, andsocial opportunities; and for governance, corporate governance.The research also identifies 37 key ESG issues. To mention oneexample, under climate change, companies are assessed based ontheir carbon emissions, energy efficiency and product carbon foot-print.

Our automation and robot theme shows a relatively good resultin terms of ESG ratings (see Fig. 18). Nearly half of companies arerated single A or higher, which is far better than the global companyaverage (30%). However, the theme has also 4% CCC rated stocks,which is slightly below average (see Fig. 19). The result shows thatinvestors keen on SI should be selective when investing in this topicas several listed companies show below-average ESG results.

Lastly, it is important to mention that our reference list is not a rec-ommendation list. And as with all investment decisions, diversifi-cation and stock selection are important for success when investingthrough a cycle.

Fig. 17: MSCI ESG Research ratings of oursecurity and safety reference listRating distribution in %, 46 companies

Note: AAA = best possible ESG rating; CCC = worstRemark: MSCI ESG ratings were available for 46 out of 61 names in ourautomation and robotics reference listSource: MSCI ESG Research, UBS, as of 16 January 2018

Fig. 18: Entire MSCI ESG Research corporatecoverageRating distribution in %, 5,915 companies

Note: AAA = best possible ESG rating; CCC = worstSource: MSCI ESG Research, UBS, as of 20 December 2017

Link to impact investing and UN SustainableDevelopment Goals (SDGs)Rapid increases in productivity, driven largely by automation, havebeen among the most powerful drivers of human development overthe last few centuries. There are many reasons to be optimisticabout the role of automation in helping achieve many of the UN'sSDGs:• There is significant scope in developing countries to increase

productivity and economic output, contributing to progress on



SDGs, including no poverty, zero hunger, good health and well-being, decent work and economic growth, and industry, inno-vation and infrastructure.

• Automation-driven reductions in the cost of manufacturedproducts make technologies including solar and wind powersystems, water filters, mobile phones and medical equipmentcheaper and more available to low-income communities.

• Industrial software, precision machinery, ubiquitous sensorsand advanced monitoring systems in manufacturing, miningand agriculture can increase resource efficiency and reducewater, energy and raw material usage. This positively impactsenvironmental SDGs like responsible consumption and pro-duction, climate action, life below water, and life on land.

• Artificial intelligence (AI) can improve health and well-beingby promoting greater efficiency in existing healthcare systems,enabling self-monitoring and allowing for early diagnosis ofmedical conditions. Machine learning can further extend theavailability of quality medical care to remote regions throughautomated diagnosis.

• Big data is increasingly being used to enhance decision-making in development efforts. Satellite imagery, combinedwith machine learning, can help map poverty more effectivelyand track illegal deforestation. Big data is also being used toimprove efficiency in building and urban infrastructure design,smart power and water grids.

However, investors must also consider the potential SDG-relatedrisks of automation. For example, automating low-skill and increas-ingly middle-skill jobs could increase workforce polarization andlead to greater inequality, at least in the short term, as new economyreturns accrue to those with capital and the highest skills. Also,increasing industrial production efficiency does not necessarily leadto greater resource efficiency as lower-cost goods can spur higherdemand and increase overall resource consumption. Furthermore,as machine learning is increasingly used to evaluate access to credit,insurance and jobs, there is risk of AI replicating human biases andfurther exacerbating discriminatory social dynamics.

Automation's potential for social and environmental impact onmultiple areas as outlined above, together with potentially highergrowth and returns from disruptive technologies like AI, make it anattractive impact theme. Currently, few impact investing solutionsfocus exclusively on automation and robotics. Investors can accessthis theme through generalist private equity and venture funds aswell as via direct investment opportunities, subject to eligibility,availability and ability to execute such investments. Artificial intelli-gence, in particular, is a current area of focus for venture capital,with over USD 5bn invested in 658 startups in 2016, according to CBInsights. When investing using non-impact-specific vehicles, impactinvestors must assess on their own whether individual investmentsmeet impact criteria including intent, measurability, verification andadditionality.

Andrew Lee, Head Impact Investing and Private MarketsJames Gifford, Senior Impact Investing StrategistNicole Neghaiwi, Impact Investing Analyst



Conclusion

We think that the current industrial revolution will turn today's man-ufacturing into smart factories over the next decade. The smartautomation industry's total annual revenues stand around USD177.5bn now. For the next few years, we have raised our marketforecast for factory as well as process automation, which likely bot-tomed last year. In particular, the outlook for factory automationin China in the coming years is very promising. We believe thatover the cycle the sector can grow by mid-to-high single digits,with industrial software, robots and the new trends discussed inthe report the clear outperformers. We expect hardware companieswith sizable software exposure to grow their automation businessby mid-single digits and pure-play software companies by high-single to low-double digits.

Overall, we think that industrial software will be a growing dif-ferentiator for companies and investors. We expect the industrialsoftware market to grow on average around 8-10%, with superiormargins. Software is at the center of this revolution, but thereis also tremendous demand for automation hardware, such asrobots, from EMs and several sectors which should lead to sus-tainable growth. One obvious example is the rising trend of mul-tiple IT devices per individual (compared to just one PC in the past),coupled with shorter product cycles (six months to one year), thatis leading to a surge in device manufacturing and increasing com-plexity. Against this backdrop, the rising trend of automation byIT vendors is evidence of the recent strong demand for industrialrobots. Other supporting long-term drivers are demographic chal-lenges in key countries like China and, in general, increasing wagesin EMs.

In summary, we see two positives in this theme: strong earningsgrowth, and re-rating potential for industrial companies withautomation software exposure. We think investors have the oppor-tunity to benefit from the automation and robotics trend over thenext few years.

We have compiled a reference list at the end of the report (see Table3). Please note that this list is only for reference and is not a recom-mendation list.

Risks

In the short term, a renewed weakness in oil prices could hinderpetrochemical investments in process automation, and peakingautomotive investments could hurt factory automation spending.And in the longer term, we see a global industrial recession as themain risk that could negatively impact automation investments.



Appendix

Terms and AbbreviationsTerm / Abbreviation Description / Definition Term / Abbreviation Description / Definition2011E, 2012E, etc. 2011 estimate, 2012 estimate, etc. A actual i.e. 2010Abn Billion CAGR Compound annual growth rateCapex Capital expenditures COM Common sharesE expected i.e. 2011E EPS Earnings per shareEV Enterprise value = market value of equity,

preferred equity, outstanding net debt andminorities

p.a. Per annum (per year)

Shares o/s Shares outstanding UP Underperform: The stock is expected tounderperform the sector benchmark

CIO UBS WM Chief Investment Office



Appendix

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Appendix

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