Technology Tax reform is a modest positive for the IT ... · As a result, investors should be aware...

US Equities InformationTechnology18 for '18: Topics, trends, and ideas for the Technology & Telecom sectors | 11 January2018Chief Investment Office Americas, Wealth ManagementKevin Dennean, CFA, Technology Equity Sector Strategist Americas, [email protected]

• 2017 was a stellar year for performance in the InformationTechnology (IT), but a year Telecom Services equity ownerswould rather forget.

• Our equity strategy group recommends a moderate overweightallocation to the IT sector and a neutral allocation to Telecom.

• We provide 18 topics, trends, and ideas that we believe will bethe center of investors' discussions for 2018.

1. Repeats are hard. We are constructive on the IT sector'sinvestment return potential in 2018, but we believe gains willbe significantly more modest than 2017.

2. IT spending is improving, finally. Continued healthy profitsglobally and improved clarity around cloud strategies shoulddrive accelerating IT spending.

3. A better balance between Value, dividends, and Growthin IT sector performance. After a year of massiveoutperformance, Growth doesn't necessarily have to sell off,but a combination of factors may benefit Value/dividendtechnology stocks.

4. Tax reform is a modest positive for the IT sector, but lessthan for other sectors. IT sector taxes are already lower thanmost other sectors.

5. Repatriation benefits are highly concentrated withinthe IT sector. We expect the largest beneficiaries to favorM&A over increasing capital returns.

6. 2018 should be another good year for IT bankers as ITsector M&A should increase off of elevated levels.

7. Cryptocurrencies will continue to "ripple" through themarkets, but the underlying value (and use case)remains cryptic. True value remains cryptic.

8. Technology investors are in the "Upside Down"...andthat may be for the best. Artificial intelligence (AI), virtualreality (VR) and augmented reality (AR) may be the mostimportant themes of the next decade, but lack pure playsin contrast to prior cycles. However that may be a positive

This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosuresbegin on page 27. UBS does and seeks to do business with companies covered in its research reports. As a result,investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.Investors should consider this report as only a single factor in making their investment decision.

given the long list of transformative technologies that werecatastrophic investments.

9. Mega cap technology companies may not be pure playson AI, VR and AR, but they have the best "real options".Valuations don't seem to reflect longer-term positioning.

10. With great data comes great responsibility...and greaterregulatory risk. Politicians and regulators globally arefocused on large internet companies unprecedented scaleand reach. Heightened regulatory may cap price/earnings (P/E) multiples, but are still constructive due to strong earningsgrowth.

11. Cloud spending remains vibrant, and hybrid is movinginto the mainstream. Better clarity on cloud strategies andhybrid cloud adoption should be a benefit for some "legacy"technology vendors.

12. The digital world is (still) a dangerous place.Cybersecurity spending should outpace overall IT budgetgrowth, but the nature of security is changing from preventionto detection and remediation.

13. Dust off your Commodore 64 - personal computers (PCs)are back! After six years of continuous declines, PCs unit salesshould stabilize in 2018.

14. Peak smartphone is upon us. The smartphone industryis likely at a peak due to the combination of saturateddeveloped markets with lengthening replacement cycles andthe inherently lower average selling prices in emergingmarkets.

15. 5G - Even sooner than we thought. AT&T and plansto launch mobile 5G service by the end of the year, andeven long-time skeptic T-Mobile USA is embracing the nextgeneration of wireless.

16. Communications equipment is poised for a comeback.After underperforming the IT sector for a decade, we believea combination of factors (improving carrier spending, new 5Gnetworks, new product cycles) and valuation makes this groupattractive.

17. We're semi-interested in semiconductors. We prefersemiconductor companies with low valuations, prospects forcyclical end-market improvement, and "real options" thataren't reflected in valuations.

18. Memory - it's not different this time...but it is differentat this time. Memory is still cyclical, but we believe the supply/demand balance will remain healthy for the next few quarters.

US Equities Information Technology

UBS Chief Investment Office Americas, Wealth Management 11 January 2018 2

1. Repeats are hard.In the 51 Super Bowls played since 1967, there have 8 repeat winners(Green Bay Packers in Super Bowls I and II, Miami Dolphins in VII andVIII, Pittsburgh Steelers in IX and X as well as XIII and XIV, San Francisco49ers in XXIII and XXIV, Dallas Cowboys in XXVII and XXVIII, DenverBroncos XXXII and XXXIII, and the New England Patriots in XXXVIIIand XXXIX. This works out to 16% repeat winners.

The odds of the top performing equity sector repeating its perfor-mance are are about half as good. As seen in the chart below, theodds of the top performing sector in the S&P 500 repeating its win-ning performance are even lower. Based on the past 15 years, thebest performing sector only had a repeat once in the past 15 years,or about 7%. Furthermore, the top performing sector actually under-performs the S&P 500 60% of the time, with average next year rela-tive performance of -3% (range of -27% for Energy in 2017 YTD to+31% for Energy in 2004).

Fig. 1: S&P 500 - Annual total returns by sector2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Total ReturnsEnergy -11% 26% 32% 31% 24% 34% -35% 14% 20% 5% 5% 25% -8% -21% 27% -1%

Materials -5% 38% 13% 4% 19% 23% -46% 49% 22% -10% 15% 26% 7% -8% 17% 24%

Industrials -26% 32% 18% 2% 13% 12% -40% 21% 27% -1% 15% 41% 10% -3% 19% 21%

Cons. Discretionary -24% 37% 13% -6% 19% -13% -33% 41% 28% 6% 24% 43% 10% 10% 6% 23%

Consumer Staples -4% 12% 8% 4% 14% 14% -15% 15% 14% 14% 11% 26% 16% 7% 5% 13%

Health Care -19% 15% 2% 6% 8% 7% -23% 20% 3% 13% 18% 41% 25% 7% -3% 22%

Financials -15% 31% 11% 6% 19% -19% -55% 17% 12% -17% 29% 36% 15% -2% 23% 22%

Info. Technology -37% 47% 3% 1% 8% 16% -43% 62% 10% 2% 15% 28% 20% 6% 14% 39%

Telecom. Services -34% 7% 20% -6% 37% 12% -30% 9% 19% 6% 18% 11% 3% 3% 23% -1%

Utilities -30% 26% 24% 17% 21% 19% -29% 12% 5% 20% 1% 13% 29% -5% 16% 12%

REITs -15% 21% 22% 7% 37% -20% -45% 21% 28% 8% 16% -2% 26% 1% 0% 7%

RankEnergy 3 7 1 1 3 1 6 9 5 7 10 8 11 11 1 10

Materials 2 2 7 6 7 2 10 2 4 10 7 7 9 10 5 2

Industrials 8 4 5 8 9 6 7 4 3 9 6 3 7 8 4 6

Cons. Discretionary 7 3 6 11 6 9 5 3 2 6 2 1 8 1 8 3

Consumer Staples 1 10 9 7 8 5 1 8 7 2 9 6 5 3 9 7

Health Care 6 9 11 4 11 8 2 6 11 3 4 2 3 2 11 5

Financials 4 5 8 5 5 10 11 7 8 11 1 4 6 7 3 4

Info. Technology 11 1 10 9 10 4 8 1 9 8 8 5 4 4 7 1

Telecom. Services 10 11 4 10 1 7 4 11 6 5 3 10 10 5 2 11

Utilities 9 6 2 2 4 3 3 10 10 1 11 9 1 9 6 8

REITs 5 8 3 3 2 11 9 5 1 4 5 11 2 6 10 9

Source: FactSet, UBS as of 2 January 2018

Although we remain constructive on prospects for the IT sector, webelieve a repeat of the strong outperformance of 2017 is unlikely.Fundamentals remain healthy across many key verticals and end mar-kets. However, valuation has generally increased, implying that atleast some of these solid fundamentals are priced in. Additionally,while we believe earnings growth will be healthy at a low double digitincrease, we do not see significant upside to 2018 estimates to thedegree seen last year.

Assuming 4Q results for the sector are in line with consensus esti-mates, 2017 IT sectors earnings will likely be 7% greater than expec-tations of a year ago. However, roughly two thirds of the upsideshould be driven by semiconductors, and approximately 50% due toMicron (Most Preferred), which has been an outsized beneficiary of



price increases in memory. While we remain constructive on memory,we nonetheless believe pricing will be much more moderate in 2018.With limited earnings upside, we do not believe it is likely that thesector will be rewarded with a higher P/E multiple.

Fig. 2: S&P 500 IT sector absolute P/E and P/E relative to the S&P 500

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Source: FactSet, UBS as 2 January 2018

2. IT spending is improving, finally.Although the IT sector has been the best performing sector in 2017and has lead all S&P 500 sectors in performance since the end ofthe Great Financial Crisis, IT spending has been surprisingly lackluster.In fact, based on 10 economic cycles since 1949, we believe that ITspending is significantly lower than it should be given where we arein the economic cycle.

In Figure 3, US IT spending growth is indexed to 100 as of the quarterthat corresponds to the trough in economic growth for each cycleas defined by the National Bureau of economic research in the post-World War II era. It's interesting to note that IBM's first mainframecomputer, the IBM 701, was introduced in 1952.

Fig. 3: US IT spending relative to GDP growthIndexed

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Source: US Bureau of Economic Analysis, UBS as of 2 January 2018

IT spending historically has lagged the overall economic recovery by aquarter or two coming out of recessions. However, it then begins tooutperform overall economic growth and this outperformance accel-



erates the longer the recovery persists. This pattern held true for thenine post-World War II recoveries. The pattern was broken followingthe "dot com" bust and recession of 2001; we attribute this to the"hangover" of overspending of the prior expansion.

IT spending has only been in line with overall economic growth in thiseconomic cycle. We attribute some of this underperformance (relativeto prior cycles) to the deflationary impact of the cloud, but perhapsmore importantly, to the uncertainty the cloud introduced to IT archi-tectures.

Recent economic data points to improving IT spending. As seen inFigure 4, after many fits and starts, growth in IT spending is beginningto outpace non-IT GDP growth. This jibes with anecdotal evidence,commentary from many IT companies, and surveys.

Fig. 4: IT spending growth vs. non-IT GDP growth

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3Q09 2Q10 1Q11 4Q11 3Q12 2Q13 1Q14 4Q14 3Q15 2Q16 1Q17Growth in IT spending - growth in non-IT GDP

Source: US Bureau of Economic Analysis, UBS as of 2 January 2018

In our view, the improvement in IT spending is driven partly due to bet-ter corporate profits globally, but more so due to clarity on the part ofcorporate IT buyers around how cloud architectures will impact theirIT operations. This clarity has driven at least some modest improve-ment in Enterprise IT spending as evidenced by a string of better thanexpected results from major IT vendors that have historically sold on-premise IT solutions as opposed to cloud-based solutions.



3. A better balance between value, dividends, and growth inIT sector performance.We have advocated a preference for growth over value and dividendsin the IT sector for much of 2017. However, as seen in Figure 5, growthhas significantly outperformed value and dividends (using data fromUBS' quantitative team) in the IT sector over the past year. On a rolling12-month basis, growth (as defined by trailing 12 months earningsgrowth) is above the 90th percentile of relative performance com-pared to value and dividend yield as measured over the past 15 years.

Fig. 5: Factor performance for rolling 6- and 12-month performanceGrowth vs. Value, Growth vs. Dividends

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Source: UBS as of 29 December 2017

We're not necessarily calling for a growth sell-off, but rather webelieve that a combination of factors could drive some outperfor-mance by value stocks within the IT sector. Valuations for many ofthe highest growth companies are near the upper end of their historicvaluations. While this alone is not a sufficient condition for share pricedecline, it certainly could limit additional outperformance.

More importantly, we think the increasing adoption of hybrid cloudcomputing may be a tailwind for legacy technology companies, whichoften are more "value" and "dividend" than "growth".

We believe fundamentals are improving for Cisco, Juniper Networks,and Intel, all of which are Most Preferred, and also have high exposureto the dividend and value factors.



4. Tax reform is a modest positive for the IT sector, but less thanfor other sectors.The recently passed Tax Cut and Jobs Act calls for a reduction in the UScorporate tax rate from 35% to 21% and for repatriation of offshoreprofits at a rate of 7% to 14%. Additionally, both plans call for aterritorial tax rate.

Based on reported figures and analyst estimates, the IT sector alreadypays approximately a 20% tax rate, essentially in line with the newstatutory rate.

We believe the IT sector could see a modest benefit from a lowercorporate tax rate, but perhaps not as much benefit as other sectorsgiven the sector's already low tax rate. This compares to our sectorstrategists' assessment of tax reform impact on the S&P 500 as seenin Figure 6.

Fig. 6: Expected tax reform impact by sector

Large-cap sectors Impact Comment

Consumer

Discretionary++

High domestic exposure benefits retailing, media, and restaurants. Possible pick-up in

consumer spending would also be supportive.

Consumer Staples +High domestic exposure benefits food and staples retailing. Mega-cap multi-nationals

also benefit from repatriation. However, competition may limit gains for shareholders.

Energy Limited

Limited benefits. Larger players have high overseas exposure, while domestic producers

pay little tax due to existing allowances. Certain domestic-based refiners, oil services, and

equipment manufacturers may benefit from a lower US corporate tax.

Financials ++High domestic exposure. Key potential beneficiary of any pick up in expectations for

faster economic growth or firming inflation.

Health Care +Health insurers (managed-care organizations) likely benefit most due to high domestic

exposure. Pharma and med-tech are more international but benefit from repatriation.

Industrials ++Domestically exposed transports, industrial distributors, and environmental services will

benefit most. Pick-up in capital spending could boost capital goods manufacturers.

Information

Technology+

Limited change to overall tax rate (lower domestic rate will be offset by limits on shifting

profits to low tax overseas jurisdictions). Key beneficiary of cash repatriation.

Materials + Less domestic exposure than the average sector.

Real Estate +

REITs don't pay corporate taxes, so limited direct impact to funds from operations.

However, could benefit from a pickup in economic growth and REIT dividend tax rates

will fall, enhancing the appeal for taxable investors.

Telecommunication

Services++

High domestic exposure. Benefits from immediate capex expensing. However,

competition may limit how much of the benefit will be retained by shareholders.

Utilities Limited Lower tax rates are passed on to consumers for regulated utilities.

Source: UBS

We also note that some large technology companies have benefit-ed from shifting intellectual property (IP) to overseas subsidiaries. Areduction in domestic tax rates will generally lower IT companies'domestic tax rates, but for some this may be offset by higher tax ratesapplied to offshore profits for some companies due to provisions in



the proposed tax reform related to base erosion prevention and taxeson IP-based revenue.

In sum, the move to a territorial tax may potentially provide somebenefit to IT companies due the lower proposed domestic rate, butthis may also pose a risk to some companies that have shifted IP off-shore. Limited financial and tax policy disclosures make a definitiveview on this issue difficult. In total, we believe the IT sector could seea very modest increase in earnings per share from lower tax rates.

5. Repatriation benefits are highly concentrated within the ITsector.Repatriation of offshore profits may have a bigger impact on the ITsector as it holds a disproportionate amount of all offshore cash withinthe S&P 500 sectors. We estimate that the top five IT companies aloneaccount for more than 40% of the near USD 1tn of offshore cash. If ITcompanies choose to use repatriated cash to increase stock buybacks,the impact could be significant. We estimate 4% EPS upside versuscurrent calendar year 2018 estimates if the largest ten companies withdisclosed offshore cash was to repatriate these funds and then use25% of net proceeds to repurchase shares. The impact increases to8% EPS upside if 50% of net repatriated cash is used for share repur-chase.

Fig. 7: S&P 500 Information Technology Sector10 largest cash balances

Company Market CapOffshore

cash% of Market

CapApple Inc. USD 890 USD 252 28%

Microsoft Corporation 680 132 19%

Alphabet Inc. Class C 716 61 8%

Intel Corporation 209 10 5%

Visa Inc. Class A 263 7 3%

Cisco Systems, Inc. 195 69 35%

Oracle Corporation 201 58 29%

Mastercard Incorporated Class A 166 5 3%

International Business Machines Corporation 150 6 4%

QUALCOMM Incorporated 98 29 30%

USD 3,570 USD 629

Source: Company filings, UBS (note that IBM offshore cash is UBS estimate)

We believe Cisco may be in the best position to capitalize on offshoreprofits repatriation as we expect the company will make acquisitionsto accelerate its transition to more software-focused business.



6. 2018 should be another good year for IT bankers.While we are comfortable with our scenario analysis for EPS buybacksensitivity, we are highly skeptical that companies will be quite soaggressive in shareholder returns due to repatriation. We note thatmany of the largest companies have issued significant amounts ofdebt over the past five years to fund share buybacks and dividends. Tobe clear, many of the IT companies with the largest offshore cash bal-ances still have some of the highest quality balance sheets in corporateAmerica. However, in our view, many technology boards, CEOs, andCFOs will likely look at repatriated funds as an opportunity to pursuetransformative or growth-oriented mergers and acquisitions. In par-ticular, we believe software companies with healthy growth prospectswill be the prime targets.

Fig. 8: Information Technology Sector M&A

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Source: Bloomberg, UBS



7. Cryptocurrencies will continue to "ripple" through the mar-kets, but the underlying value (and use case) remains cryptic.Cryptocurrencies including Bitcoin, Ethereum, Litecoin, and Rippledominated the financial press for much 2017. As discussed in Cryp-tocurrencies: Beneath the bubble, 12 October 2017, we believe thatcryptocurrencies are not actually currencies at all. Bitcoin and its ilk failto satisfy two of the basic requirements of a currency as they are nei-ther a widely accepted medium of exchange nor are they truly storesof value.

Fig. 9: Bitcoin price

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Bulls and the more libertarian minded point towards the ultimatelylimited supply of any single cryptocurrency. While this is true, it alsotrue that there is no mechanism for reducing a cryptocurrency supplyin response to falling demand, so the only response to falling demandwill be a likewise collapse in price.

The more favorably disposed might argue that this could never hap-pen, or that the leading cryptocurrencies are the leading edge of anew economic paradigm. However, we nonetheless see risks - whilethe supply of any single cryptocurrency may be finite, the supply ofcryptocurrencies are infinite as seen in the more than 1,000 initial coinofferings (ICOs) in 2017.

Bitcoin and its digital brethren will "ripple" (pun intended) throughthe markets and the financial media. However, in our view their trueintrinsic value and their ultimate use case remains cryptic.



8. Technology investors are in the "Upside Down"...and thatmay be for the best.AI may ultimately be the most important technology development ofour times. AR and VR also hold tremendous promise. These technolo-gies collectively will likely underpin investment themes for the nextdecade or more given their truly transformative nature and their abil-ity to serve as a platform for any number of vertical applications.

Fans of Netflix's "Stranger Things" know that the Upside Down isalternative dimension that looks like our world, but much darker, cold-er, foggier, and dangerous and inhabited by monsters.

In our view, technology investors likely feel as though they are in"the Upside Down" relative to AI, VR, and AR in that the best posi-tioned companies are not pure plays in these areas, but rather mega-cap technology companies like Amazon (covered by CIO Americas,Wealth Management consumer discretionary sector strategist RobertSamuels), Google, Facebook, and Microsoft. Unlike prior technologycycles (the internet build out and the dot com era of the '90s, the riseof internet advertising in the early '00s, and the rise of cloud comput-ing and software-as-a-service in the past decade), there are no pureplays in AI, VR, or AR.

As frustrating as the lack of pure-play investments might seem, thisironically may be for the best from an investment perspective. Whilethese technologies are undoubtedly important, there is a long historyof transformative technologies that held almost unbounded promisebut yet proved to be catastrophic investments. The dot com era lefta trail of wreckage in its wake, ranging from telecom bankruptcies,90%-95% declines in the market cap of many optical equipmentcompanies, to wholesale purging of many e-commerce companies.

Even if an investor picked the ultimate winner in these pure plays,investment success proved to be a long-term process: an investment inAmazon on 31 December 1999 did not breakeven versus the S&P 500(including dividends) until late 2004 and shareholders had to endurerelative underperformance of approximately -85% during that timeperiod and additional underperformance of -65% from late 2004through mid-2007.



9. Mega cap technology companies may not be pure plays onAI, VR and AR, but they have the best "real options".Some pundits refer to AI as potentially mankind's last invention. VRalso holds significant promise across gaming, entertainment, educa-tion, design, medicine, and retail.

However, as noted previously, we believe that the leading companiesin these fields are often the mega-cap technology companies. As seenin Figure 10, Microsoft and Google were the first and eighth mostfrequently cited source for AI research papers.

Fig. 10: Most quoted AI research papers by source2012 - 2016

Rank Organization Quote1 Microsoft 6,528

2 Nanyang Technological University 6,015

3 Chinese Academy of Sciences 4,999

4 CNRS 4,492

5 Carnegie Mellon University 4,389

6 University of Toronto 4,315

7 Massachusets Institute of Technology 4,283

8 Google 4,113

9 Tsinghua University 3,851

10 New York University 3,506

Source: Asian Nikkei Review

Although Amazon and Facebook do not appear in this list, wenonetheless believe that both companies have made significantinvestments in AI.

In our view, investors cannot hold a positive view on the leadingtechnology companies based solely on their positioning within AI,AR, or VR with any reasonable investment time horizon as thereare simply too many other variables at play. For instance, Google iswell recognized for its AI capability and we would argue that AI iswoven throughout Alphabet's business. However, investment returnsfor GOOGL/GOOG over the next few years will likely be driven by fac-tors other than AI: the ongoing transition of traditional advertising todigital, traffic acquisitions costs (i.e., the amount that Google pays itsadvertising partners), cost controls, and overall execution.

We nonetheless believe Google's positioning in AI is a true asset tothe company. In our view, investors should view Google's, Microsoft's,and other large cap technology companies' AI strengths through theview of "real options".

Similar to financial options like puts or calls, real options are the abilityof companies to make business decisions, such as investing in a newline of business, pursuing acquisitions, or research and development(R&D). In essence, real options are the ability of a company to driveits business. Real options are grounded in a company's managementability, market positioning, access to capital, access to talent, and oth-er tangible and intangible factors.



In our view, mega-cap technology companies such as Alphabet (theholding company for Google), Facebook, Microsoft, and others are"long" real options by virtue of their sheer scale, their access to tal-ent, proven management ability, and ability to invest in R&D and sub-sequently bring products to market.

The concept of real options is not new; it was popularized in the late1990s during the "dot com" era. In some cases it was abused is asmuch that real options were sometimes used to justify stock excessivevaluations.

However, we believe that valuations today of many large cap tech-nology companies do not reflect their real options. For example, con-sensus estimates call for Alphabet to grow earnings by approximatelya 20% CAGR over the next few years and the shares trade at 27xforward earnings. In our view, this seems to give little to no credit toGoogle for its strong positioning in AI (as seen in the figure above),against a USD 15.7tn 2030 market opportunity (as estimated by PwC).

The bottom line is that although mega-cap technology companiesmay not be directly investable because of AI, AR, or VR, shareholdersare long "free" real options since the market does not seem to befactoring these into valuations.

10. With great data comes great responsibility...and greaterregulatory risk.We know we're not the first to make this statement, but data is thenew oil. Data becomes a more important corporate asset with everypassing day. In our view, the large global internet companies sit atopsome of the richest piles of data as a result of consumers' web brows-ing, video consumption, email, ecommerce, and social media posts,along with user bases that are in the billions globally.

As evidenced by recent discussions and actions, regulators apparentlyagree. The General Data Protection Regulation goes into force on 25May 2018 in Europe. This new law establishes a higher level of respon-sibility for the custody and protection of personal data, along withnew remedies against companies that abuse personal data. Penaltiescan be severe, with penalties of EUR20mn or up to 4% of global rev-enue, whichever is greater.

At the same time, there is increasing concern among lawmakers andregulators in regard to the reach and scale of internet platforms rela-tive to media content and news. German regulations took effect on1 January 2018 requiring social platforms to remove criminal contentwithin 24 hours, with fines of up to EUR 50mn for non-compliance.Facebook and Twitter have until 18 January 2018 deadline to complywith a British investigation of "fake news" during Brexit campaign.Google paid a USD 2.8bn fine to the European Union after regulatorsdetermined it illegally promoted its own price comparison services insearches, and the company faces two more continuing investigationsrelated to its alleged dominance in search advertising and its owner-ship of the Android mobile operating system.



We expect regulatory risk to be heightened for the foreseeable futureas politicians, regulators, and courts worldwide wrestle with issuesrelated to the internet companies' collective dominance. Although webelieve the probability of structural remedies such as a breakup ordivestiture are remote, we nonetheless believe that greater regulato-ry risk will serve as an overhang to sentiment and likely limit any P/E multiple expansion. With multiples held constant, stock price per-formance will be driven by earnings growth, which we believe willremain healthy.

Fig. 11: Alphabet (GOOGL) and Facebook P/E multiples

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We continue to have a Most Preferred view on Alphabet, the holdingcompany for Google. We believe the company should benefit fromthe continued transition to digital advertising, solid cost controls, andthe potential for additional capital returns. Additionally, we think thecompany has an underappreciated position in cloud and AI.



11. Cloud spending remains vibrant, and hybrid is moving intothe mainstream.Public cloud revenues have grown at a 35% CAGR over the past threeyears to USD 105bn in 2017E, based on estimates by industry analystGartner. After nearly a decade of discussion and the Amazon WebServices (AWS), Microsoft's Azure and Office365, and software-as-a-service (SaaS) pure plays Salesforce.com, Workday, and ServiceNow,and others, we believe there is almost a level of fatigue with cloudcomputing as an investment theme.

However, we believe cloud computing is still in the early days. Gartnerprojects public cloud spending will grow at a 23% CAGR over thenext three years. We believe this could be conservative as it still wouldamount to only 10% of global enterprise IT spending (software + datacenter systems + IT services).

Fig. 12: Gartner public cloud computing forecasts

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Source: Gartner, UBS

We believe that one reason IT spending is improving is because enter-prise IT departments have increased clarity and confidence aroundtheir cloud strategies. Cloud adoption is moving well beyond ear-ly adopters, start ups, and dev-ops (i.e., software development andoperations) and into more mission critical workloads. Security is stilla paramount concern, but cloud service providers have made strongprogress on data rights management issues while maintaining andadmirable record on breach protection.

While public cloud (i.e., Amazon AWS, Microsoft Azure) and privatecloud (i.e., a multitenant data center owned and operated by a cor-poration) for the are fairly well accepted computing constructs, webelieve hybrid cloud computing will drive the next wave of cloudadoption as it becomes a mainstream cloud strategy. Hybrid clouduses a mix of on-premise private cloud resources along with office-premise third-party public cloud resources. Hybrid cloud can delivermultiple benefits including better IT asset utilization, improved agility,and security. Additionally, a hybrid cloud strategy can protect againstvendor lock-in, a non-trivial concern given past experiences and thecriticality and cost of technology operations.



As seen in the graph below, a survey by Rightscale (a provider of cloudmanagement tools) indicates that 85% of survey respondents planon pursuing a multi-cloud strategy, with 58% intending to pursue ahybrid cloud strategy. We believe this supports the strong growth inhybrid cloud forecasted by industry analyst IDC, which expects hybridcloud to increase to more than USD 21bn by 2021 from approximatelyUSD 12bn in 2017.

Fig. 13: Cloud strategy survey

Single public,9%

Singleprivate, 5%

No plans, 1%

Multipleprivate, 7%

Multiplepublic,20%

Hybrid cloud,58%

Source: Rightscale, UBS

In our view, legacy IT vendors such as Cisco should benefit from hybridcloud adoption. We also see select IT consulting companies such asAccenture as well-positioned to capitalize on the continued migra-tion to the cloud and ramping hybrid cloud adoption. Red Hat shouldbenefit from its leading position in OpenStack and OpenShift, whichboth provide key management tools for cloud computing environ-ments. We also believe Intel and Micron should benefit from contin-ued cloud data center server investment as well as stable to betterdemand trends for on-premise servers.



12. The digital world is (still) a dangerous place.After a stellar run from 2012 to 2015, many cyber security stockshave underperformed the S&P 500 and the IT sector. However, thedigital world continues to be a dangerous place. As seen in Figure 14,security breach activity in the US remains elevated. The most recentspike in breaches is due to the Equifax hack of September 2017 inwhich the data of over 145mn consumers was compromised.

Fig. 14: US cyber security breaches - number of records compromisedin millions

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1Q05 3Q06 1Q08 3Q09 1Q11 3Q12 1Q14 3Q15 1Q17

Number of records breached (mn)

Source: Privacy Rights Clearinghouse, UBS

The fundamental backdrop still, unfortunately, remains positive forcybersecurity vendors. Hacking has evolved from simple "script-kid-dies" pulling cyber-pranks to impress their friends to sophisticatedorganized crime operations, nation-state actors, and politically-moti-vated "hacktivists". This should support continued increases in ITsecurity budget. As seen in Figure 15, industry analyst Gartner fore-casts the cyber security market to grow 8% in 2018.

Fig. 15: IT security spending

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Identity AccessManagement


However, as can also be seen in Figure 15, the composition of spend-ing is changing. Chief Security Officers (CSOs) increasingly recognizethat breaches are practically inevitable. Rather than focusing primarily



on prevention (which drove outsized growth in firewalls that protectthe perimeter over the past few years), CSOs are pivoting to focus ondetection and remediation. At the same time, CSOs are dealing with"too much technology" (i.e., too many vendors, too many securityplatforms) and too few people.

Putting it all together, we believe security spending will increasinglybe driven by analytics and monitoring. Additionally, security servicesspending should benefit. Lastly, we expect to see consolidation withsecurity on two fronts. First, we believe vendors that can consolidateadjacent security functions will be significant share gainers as consol-idation allows CSOs to address "too much technology" and leveragescarce (and expensive) security professionals. Second, we expect therewill be significant consolidation in the security space as vendors raceto provide more of an integrated security platform. Firewall spending,which has decelerated sharply, will likely remain tepid for some time,though we note that firewall vendors are well positioned to play therole of consolidators of both adjacent technology and security com-panies.

In our view, Splunk is incredibly well-positioned for the increasing useof analytics in security. The company is a leading provider of softwareused to capture and analyze data from IT operations; this is a criticalcapability that addresses a true pain point for CSOs. We continueto believe Cisco's (Most Preferred) is well positioned in security andthe company will likely continue to make smart acquisitions in thisspace to further provide integrated solutions. Additionally, by virtueof its dominance in enterprise network infrastructure, the companyshould be able to drive real product synergies across the networkingstack. Lastly, firewall vendors Palo Alto Networks and Fortinet (bothon our Beneficiaries of Transformational Technologies list) certainlyface headwinds from slowing firewall demand, but at the same timeare well positioned to play the role of consolidators.



13. Dust off your Commodore 64 - PCs are back!After five years of continuous unit declines, we believe PCs will returnto growth in 2018. To be clear, growth will be modest, but the benefitsto PC semiconductor providers should be substantial as a five yearheadwind is now neutralized.

Fig. 16: Global PC units

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In our view, PC demand is improving due to several factors. First, anaged installed base is ripe for upgrade just as Windows 10 beginsto see corporate adoption. PC manufacturers have developed inno-vative form factors that combine the content creation capabilities ofa full fledged computer along with the content consumption ease ofa table. Additionally, we believe the tablet market "experiment" ofsubstituting tablets for PCs has largely proven to be a failure, withtablet functionality being subsumed into the convertible PC form fac-tor. Lastly, the increasing adoption of "phablets" (large screen smart-phones) lessens the need for a dedicated tablet device.

We may never again see the glory days of the Commodore 64 era,but we nonetheless believe the PC industry has finally stabilized. Intel,which has dominant share in PC processors, should be an outsizedbeneficiary along with Micron, as DRAM demand should be support-ed by a stable PC market.

14. Peak smartphone is upon us.It's not just you. Everyone walking through Manhattan, San Francisco,Chicago, and Boston has their face buried in their smartphones. (LosAngelinos are in their cars.) The same holds true in many major citiesacross the world.

We believe the world is approaching "peak smartphone" due toa combination of developed market saturation and inherently low-er average selling prices in the emerging markets. Industry revenuegrowth has slowed to mid-single digits (off a very soft -1% in 2016)after growing at a 23% CAGR over the past decade.

As seen in Figure 17, industry revenue is expected to reaccelerate to12% in 2018 before posting actual declines in 2019 and 2020. Unitgrowth should remain tepid in the low single digit range (see Figure18), while ASPs are expected to increase sharply in 2018 (see Figure19). We believe there is significant risk to these estimates.



Fig. 17: Global smartphone revenue

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Source: UBS as of 20 November 2017

Fig. 18: Global smartphone units

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Fig. 19: Global smartphone average selling pricesSource: UBS as of 20 November 2017

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Beyond 2018, we see unit growth in developed markets facing head-winds from saturation, as smartphones account for a very high per-centage (often 80%+) of the subscriber base in the United States,Germany, France, the United Kingdom, Spain, Italy, Japan, Sweden,Norway, Finland, and the Netherlands. In these markets we believethe replacement rate of the installed base will continue to extend asless innovation is brought to market and consumers hold on to theirphones for longer periods of time.



Emerging markets such as India offer unit growth opportunities, butoften at the cost of significantly lower average selling prices. Webelieve this is not a function of consumer preferences, but simplyreflects telecom service providers' and consumers' economics. Forinstance, the average monthly revenue per user for the major Indi-an telecom carriers is less than USD 3/month. This compares to USD35-45 in the US and USD 7-9 in China. In our view, this low revenuerate means that consumers are constrained in their ability to purchasehigh-end devices and carriers are similarly unable to subsidize devicesin any meaningful way.

15. 5G - Even sooner than we thought.5G is the next phase in the evolution of wireless technology. As withprior generations, 5G will enable faster wireless broadband speedsat lower costs. Importantly, when fully implemented, 5G is expect-ed to enable new applications such as autonomous driving, massiveinternet of things ( IoT), and telemedicine, among others. In the moreintermediate-term, 5G will be deployed first as an alternative broad-band access technology, with this "third pipe" of fixed wireless accesspotentially enabling new competition.

In 5G: Sooner than you thought, different than you imagined, 22March 2017, we wrote that:

"Although widespread adoption of mobile 5G wirelessremains a few years away, the wireless industry is movingquickly and field trials of 5G fixed wireless access are plannedfor this year."

It turns out that 5G is arriving even sooner than we expected. AT&Tannounced on 4 January 2018 its plan to mobile 5G in a dozenmarkets by the end of this year. Additionally, long-time 5G skeptic T-Mobile US announced its intent to have a "real, mobile nationwide 5Gnetwork" (as opposed to fixed wireless access) by 2020. We believeit is highly likely that T-Mobile may accelerate this schedule if AT&T's5G efforts show early signs of success.

Meanwhile on the fixed access front, Verizon confirmed it will launcha 5G offering to provide internet services in Sacramento CA in late2018 with additional trials in other cities.



Fig. 20: Mobile Technologies

1G 2G 3G 4G 5GAdds to 4G use cases:

Wireless speeds upto 1Gb/second

Massive Internet ofThings (IoT)

4K video

Connected cars

Telemedicine

Mission criticalnetworks

Source: UBS

16. Communications equipment is poised for a comeback.The communications equipment industry is the worst performinggroup in the S&P 500 IT sector over the past 1, 3, 5, and 10 year peri-ods. The industry has been pressured by increasing standardizationand the rise of Chinese vendors such as Huawei and ZTE. Increasingstandardization has decreased vendors’ ability to differentiate theirproducts and therefore earn attractive margins. The Chinese vendorsfor many years were focused on growth over profits and as a resultbrought significant pricing pressure to the market. Additionally, manycompanies have extended the useful life of switching gear, whichresulted in yet another headwind to growth.

Fig. 21: Total returnsindexed to 100 as of 31 Dec. 2007

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'07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17S&P 500 IT Sector S&P 500 S&P 500 Comm Equip.


However, we believe 2018 may finally mark an inflection for commequipment providers. While the competitive environment is still neu-tral at best, we see multiple reasons for optimism this year. Globalcarrier cap ex will most likely decline in 2018, but annual compar-isons improve in 2H18 (and the US is already improving; see Figure22). At the same time, we believe carriers will begin initial 5G net-work builds and rollouts. While this may not yet be significant rev-enue opportunity, we believe 5G successes should carriers' spending



plans for 2019 and improve sentiment towards the communicationsequipment group.

Fig. 22: US carrier capital expenditures

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AT&T Verizon Sprint T-Mobile USA CenturyLink*

* CenturyLink data adjusted for its acquisition of Level 3Source: FactSet, UBS

Additionally, we believe enterprise investment will improve as busi-nesses (finally) begin to upgrade their network infrastructures to takeadvantage of new services. These new offerings include as SD-WAN(a new networking product/technology used to provide connectionsto branch offices and data centers at low costs over large distances);new software defined networking solutions for the data center; andnew demand drivers from industrial applications and the IoT.

In our view, Cisco should be a beneficiary of improving enterprisedemand, new product cycles, and new demand drivers. Juniper Net-works should benefit from improving carrier spending and contin-ued investment by cloud service providers. Finally, we believe Ericssonand Nokia (both of which are on our Beneficiaries of TransformationalTechnologies list) will benefit from continued 4G investment and theupcoming ramp in 5G spending.



17. We're semi-interested in semiconductors.The semiconductor industry is much more diversified today whencompared to prior cycles, a clear positive for a notoriously cyclicalindustry. However, we're only semi-interested in semiconductors atthis time due to valuations that seem to largely ignore the risks of acyclical downturn, or even the revenue slowdown anticipated by boththe Semiconductor Industry Association and consensus estimates.

Fig. 23: Semiconductor industry revenue

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2005 2007 2009 2011 2013 2015 2017E

Reve

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inbill

ions

Global Semiconductors Semiconductors ex-Memory

Source: Semiconductor Industry Association, UBS

As seen in Figure 23, the global semiconductor industry is expectedto grow 7% in 2018 to USD 437bn, a marked deceleration from the21% growth expected for 2017. This slower growth rate is primarilydue to a more stable pricing environment in memory. Although we arestill constructive on the memory market (discussed in detail below),we nonetheless believe that a repeat of the exceptionally strong pric-ing environment of 2017 is unlikely; we estimate that higher pricesaccounted for roughly half the increase in memory industry revenues.

Analog semiconductor companies have been some of the strongestperformers of this cycle. The analog group has benefitted fromincreasing demand across a swath of industries, the benefits of con-solidation, and strong operating leverage. This has driven significantearnings growth and P/E multiple expansion.

However, as seen in Figure 24, earnings growth estimates have beendeclining (now 11% for 2018), while P/E multiples are near five yearhighs.



Fig. 24: Analog semiconductor groupTXN, SWKS, QRVO, ADI, LLTC, MXIM

15x

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Earnings Growth P/E


Rather than fully valued analog names with expected deceleratingearnings growth, our preference is for semiconductor companies withlow valuations and prospects for cyclical earnings improvement and"real options" as discussed earlier. In this vein, we believe Intel iswell positioned. The company should benefit from a stable PC mar-ket (a first in five years), continued strong demand from cloud ser-vice providers, and strong gains in its communications chip business.Additionally, we believe Intel has real options in autonomous driving(through its Mobileye acquisition) and in AI, where we believe com-pute demand will increase. Lastly, the stock trades at a 14x P/E versusconsensus next twelve months earnings, which is a 25% discount tothe semiconductor group average and offers 2.6% dividend yield.

18. Memory - it's not different this time...but it is different atthis time.Prices for DRAM and NAND memory were incredibly strong in 2017,as seen in Figure 25.

Fig. 25: DRAM Spot Pricing

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Mar-13 Mar-14 Mar-15 Mar-16 Mar-17DRAM Spot Pricing


Our memories of prior memory cycles make us say that it's not "dif-ferent this time", but it is "different at this time". What's differentat this time? Industry consolidation has lead to a newfound capacity



discipline, which has resulted in a better supply balance. At the sametime, demand drivers are less reliant on PCs as seen in Figure 26.

Fig. 26: DRAM industry revenue by end market

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Mobile phones PCs Servers Tablets, eReaders Gaming Auto Other

Source: Bloomberg

We believe the supply/demand balance will remain healthy for thenext few quarters, particularly in DRAM. PCs as a demand driverhas been replaced by smartphones, a category we are cautious on.In the near- to intermediate-term, increasing memory density (i.e.,the amount of memory per device) should counteract slowing unitgrowth, but longer-term we expect bit demand from mobile devicesto flatten out. Servers should continue to be strong as cloud serviceproviders deploy very memory-dense servers and automotive shouldcontinue to consume more bits. This demand drivers are construc-tive to the longer-term picture, but we would not be surprised to seeanother memory downturn towards the end of 2018.

We believe Micron is attractive at current levels given its positioningin DRAM, continued capital and cost dividend. The stock trades atless than 5x consensus next 12 months estimates, and we believeestimates are likely understating the earnings power for 2018.



Appendix

Statement of Risk

Equities - Stock market returns are difficult to forecast because of fluctuations in the economy, investor psychology,geopolitical conditions and other important variables.

Terms and AbbreviationsTerm / Abbreviation Description / Definition Term / Abbreviation Description / Definition

1H, 2H, etc. or 1H11,

2H11, etc.

First half, second half, etc. or first half 2011,

second half 2011, etc.

1Q, 2Q, etc. or 1Q11,

2Q11, etc.

First quarter, second quarter, etc. or first quarter

2011, second quarter 2011, etc.

2011E, 2012E, etc. 2011 estimate, 2012 estimate, etc. A actual i.e. 2010A

CAGR Compound annual growth rate E expected i.e. 2011E

EPS Earnings per share GDP Gross domestic product

Market cap Number of all shares of a company (at the end of

the quarter) times closing price

NAV Net asset value

P/E Relative P/E relative to the market Shares o/s Shares outstanding

WMR UBS Wealth Management Research CIO UBS Chief Investment Office

x multiple / multiplicator YTD Year-to-date

Required Disclosures

Analyst Certification

Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that withrespect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflecthis or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be,directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the researchreport.

Companies mentioned in this report (11 January 2018):Cisco Systems Inc. (CSCO - Most Preferred, $40.10), Ericsson (ERIC - , $6.89), Fortinet, Inc. (FTNT - Bellwether, $44.26),Alphabet Inc. Class A (GOOGL - Most Preferred, $1,112.05), Intl Business Machines (IBM - Least Preferred, $164.20),Intel Corp. (INTC - Most Preferred, $43.41), Juniper Networks Inc. (JNPR - Most Preferred, $28.76), Micron Technology(MU - Most Preferred, $42.82), Nokia (NOK - , $4.82), Palo Alto Networks (PANW - Not Rated, $154.16), Red Hat (RHT- Most Preferred, $126.16), Splunk (SPLK - Most Preferred, $89.45), AT&T Inc. (T - Most Preferred, $36.48), VerizonCommunications Inc. (VZ - Least Preferred, $52.11)

CIO Americas, Wealth Management equity selection systemEquity sector strategists provide three equity selections: Most Preferred (MP), Least Preferred (LP) and Bellwetherdesignation.

Rating definitionsMost Preferred*: The equity sector strategist expects the stock to outperform the relevant benchmark in the next 12months.Least Preferred*: The equity sector strategist expects the stock to underperform the relevant benchmark in the next12 months.Bellwether: Stocks that are of high importance or relevance to the sector and which the equity sector strategist expectsthe stock to perform broadly in line with the sector benchmark in the next 12 months.*A stock cannot be selected as Most Preferred if UBS Investment Research rates it a Sell, while a UBS Investment ResearchBuy rated stock cannot be selected as Least Preferred.

Restricted: Issuing of research on a company by CIO Americas, WM can be restricted due to legal, regulatory, contractualor best business practice obligations which are normally caused by UBS Investment Bank’s involvement in an investmentbanking transaction in regard to the concerned company.



Appendix

Equity selection: An assessment relative to a benchmarkEquity selections in Equity Preferences lists (EPLs) are relative assessments versus a sector/industry, country/regional orthematic benchmark. The chosen benchmark is disclosed on the front page of each EPL.Stocks can be selected for several EPLs. To keep consistency, a stock can only be selected as either Most Preferred or LeastPreferred, but not both simultaneously. As benchmarks differ between lists, stocks need not be included on every list towhich they could theoretically be added.

For a complete set of required disclosures relating to the companies that are the subject of this report, please mail arequest to UBS CIO Americas, Wealth Management Business Management, 1285 Avenue of the Americas, 20th Floor,Avenue of the Americas, New York, NY 10019.

UBS Investment Research: Global Equity Rating DefinitionsFor information on the ways in which UBS manages conflicts and maintains independence of its research product;historical performance information; and certain additional disclosures concerning UBS research recommendations, pleasevisit www.ubs.com/disclosures.Global Equity 12-Month Rating DefinitionsBuy: FSR is > 6% above the MRA. Neutral: FSR is between -6% and 6% of the MRA. Sell: FSR is > 6% below the MRA.Key DefinitionsForecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over thenext 12 months.

Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and nota forecast of, the equity risk premium).

Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or ratingare subject to possible change in the near term, usually in response to an event that may affect the investment case orvaluation.

Exceptions and Special CasesCore Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment ReviewCommittee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respectivecompany's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as theyrelate to the rating. When such exceptions apply, they will be identified the Companies Mentioned or Company Disclosuretable in the relevant research piece.

Disclosures (11 January 2018)Alphabet Inc. Class A 2, 6, 7, 10, 11, 12, 13, AT&T Inc. 1, 2, 3, 4, 6, 7, 15, 17, Cisco Systems Inc. 1, 2, 3, 4, 5, 6, 7,Ericsson 4, Fortinet, Inc. 4, 8, 9, Intel Corp. 1, 2, 3, 4, 5, 6, 7, 9, 14, Intl Business Machines 2, 4, 6, 7, 14, Juniper NetworksInc. 2, 4, 5, 15, Micron Technology 4, Nokia 2, 4, Palo Alto Networks 4, Red Hat 1, 2, 3, 4, 5, 6, 7, 8, 9, Splunk 4, 16,Verizon Communications Inc. 1, 2, 3, 4, 6, 7, 18;

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http://www.ubs.com/disclosures

Appendix

9. Financial Services Inc., its affiliates or subsidiaries owns a net long position exceeding 0.5% of the total issued sharecapital of this company.10. past 12 months, UBS Securities LLC and/or its affiliates have received compensation for products and services orthan investment banking services from this company/entity.11. LLC makes a market in the securities and/or ADRs of this company.12. is, or within the past 12 months has been, a client of UBS Securities LLC, and non-securities services are being, orhave been, provided.13. is, or within the past 12 months has been, a client of UBS Securities LLC, and non-investment banking securities-related services are being, or have been, provided.14. company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-securities servicesare being, or have been, provided.15. AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking servicesfrom this company/entity within the next three months.16. equity analyst covering this company, a member of his or her team, or one of their household members has a longcommon stock position in this company.17. Securities LLC is acting as manager/co-manager, underwriter, placement or sales agent in regard to an offering ofsecurities of this company/entity or one of its affiliates.18. AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities ofthis company/entity or one of its affiliates within the past 12 months.



Appendix

Disclaimer

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UBS Financial Services Incorporated of PuertoRico is a subsidiary of UBS Financial Services Inc. UBS FinancialServices Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributes reportsto US persons. All transactions by a US person in the securities mentioned in this report should be effected through aUS-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have notbeen and will not be approved by any securities or investment authority in the United States or elsewhere. UBS FinancialServices Inc. is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section15B of the Securities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are notintended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule.UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior writtenpermission of UBS. UBS accepts no liability whatsoever for any redistribution of this document or its contents by thirdparties.Version as per September 2017.



Appendix

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