Longer Term Investments

Security and safety

Chief Investment Office Americas, Wealth Management | 19 April 2018 10:19 pm BST
Alexander Stiehler, CFA, Analyst; Sundeep Gantori, CFA, CAIA, Analyst

• Security and safety touch lives everywhere. Governments need

to keep infrastructure safe and functioning, enterprises must
protect data and consumers have to trust products like baby
food.
• Growing trends toward urbanization, stricter regulation and
greater consumer awareness about product quality, data
security, environmental protection and social responsibility are
just a few factors that support the theme. It ranges from high-
tech cyber-security solutions to traditional security equipment.
• We think the addressable market is a defensive one that offers
attractive growth rates in the mid- to high-single-digits over the
next 5-10 years. We estimated its overall size at around USD
600bn last year, and think it will exceed USD 700bn by 2020
(around 6% annual growth). We recommend investing in it in
a well-diversified way to gain exposure to the entire security
and safety value chain worldwide.

Our view
Cyber security, along with other security and safety risks, remains a
major challenge as the world becomes more and more connected
and, hence, vulnerable. The WannaCry ransomware attack last year
again highlighted the need for secure systems as it affected users in
more than 150 countries. The stage is set for increased scrutiny. In
May the EU implements its new "General Data Protection Regulation
(GDPR)" that brings a material risk of fines (up to 4% of global
revenues for noncompliance), driving further investment in cyber-
security.
The global security and safety market is a thematic investment idea
that benefits not only from structural trends such as rising cyber-
attacks but from threats to the global food chain and to air, water
and soil quality. Our investment theme also covers security solutions
for such traditional end-users as airports, mass transit systems, ports,
power plants (and other energy providers) and homeowners. We
discovered that making the world a safer place offers interesting
business opportunities.
The good news in a rising risk environment is that the security and
safety industry is succeeding in helping us avoid danger. With greater
innovation and investment, the addressable market should continue
to grow at rates in the mid-to-high single digits, depending on the
sub-sector. Also, the industry is not especially cyclical and appeals to
growth and quality-focused investors alike.

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

While we expect sales in the market to rise 6% annually during Fig. 1: Urban and rural populations
2017-2020, we expect profits to increase more rapidly due to margin 1950-2050E (in billion)
expansion arising from an improving product mix (more software 7

sales) in the cyber-security sub-sector. 6

5
Introduction 4
Long-term trends such as urbanization, stricter regulation and 3
growing consumer awareness about product quality, data security, 2
environmental protection and social responsibility support our security 1
and safety theme. We examine the most important and, in our view, 0
most promising parts of its value chain: 1) cyber-security; 2) testing,

1950
1954
1958
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
2014
2018E
2022E
2026E
2030E
2034E
2038E
2042E
2046E
2050E
inspection and certification companies; 3) life science tools; and 4) the Urban Rural
commercial and residential construction security sector. We excluded
the basic guarding segment of the market as we think it will expe- Source: United Nations, Population Division – World
Urbanization Prospects: The 2014 Revision
rience long-term structural pressure from technological solutions. A
short concluding section touches on where this theme overlaps with
the topic of sustainable investing. Fig. 2: More connected devices mean more
security risks
Aside from the individual drivers of each sub-sector, we have iden- Connected
Devices
500
M illion
12.5 Billion 25
Billion
50
Billion
tified one long-term trend that links them all: urbanization. It leads
to higher population density and more social differences. Both imply
greater tensions and insecurity. For example, the rate of property More
Connected
crime in the US is much higher in urban than in rural areas (based Devices
connected
devices than
Per Person 0.08 1.84 3.47 6.58
on 2011 numbers), according to the US National Crime Victimization people

Survey. In emerging markets (EMs), an expanding urban middle class 2003 2010 2015 2020

can afford more security products and services, which should boost Source: Cisco, UBS, as of April 2015
sector growth. In 1950, only 29% of the world's population lived
in cities. By 2008, urban dwellers had exceeded rural ones. The UN
expects this trend to continue, with 70% of the global population
residing in cities by 2050 (see Fig. 1).
While most developed country inhabitants were already concentrated
in urban areas by the mid-20th century, EM residents are still catching
up. The urbanization trend will create major challenges and com-
pelling investment opportunities, in our view. A case in point is the
rising number of connected devices – PCs, smartphones and wearable
devices – worldwide (see Fig. 2), which is leading to increased com-
plexity and exposing users to security risks.

Cyber-security
Cyber-security poses a serious threat to individuals, corporations and
governments alike. While the 2013 leak of classified information to
a newspaper by Edward Snowden, a former US government con-
tractor, served as an inflection point for the cyber-security debate, the
ongoing security attacks on major companies highlight that nothing
is fully secure. According to Bloomberg Intelligence and IBM, global
cyber security incidents continue to rise 20-30% every year.
While cyber-security has been largely associated with computers and
IT infrastructure, greater consumer use of smart devices like smart-
phones and tablet PCs has raised overall vulnerability to cyber-threats.
At the enterprise level, shifting to cloud computing has cut company
costs significantly while raising the risk of an online attack. Perpe-
trators have become more sophisticated.

Chief Investment Office Americas, Wealth Management 19 April 2018 2

Longer Term Investments

Early aggressors mainly targeted personal information, but the latest Fig. 3: Per capita cost of data breaches for key
malicious attacks, such as the incidents at Yahoo!, Target and eBay, markets
250
have brought entire corporate IT infrastructures to a standstill. Cyber-
attackers' intentions have also shifted from gaining notoriety to ben- 200
efiting financially or politically.
150
Cyber-crime has broader consequences than merely exposing the vul-
nerabilities of the affected party. It also damages trade, competi- 100
tiveness and innovation at the macro level.
50
A study done by IBM and Ponemon highlights that the per capital
cost of data breaches in 2016 was as high as USD 221 in the US or
0
USD 213 in Germany (see Fig. 3). It cost the global economy billions US Gerrmany Canada France UK Italy Japan

of dollars. Furthermore, we believe cyber-crime has serious implica- Per capita cost (USD)

tions for employment as repeated cyber-threats can jeopardize new Source: Ponemon, IBM as of 2016
investment and, in turn, job creation.
Despite the broad-based implications of cyber-security risks, busi- Fig. 4: R&D spending by major internet plat-
nesses are ill-prepared for them, in our view, as the rising number forms on security (USD million)
6,000
of threats clearly indicates. What do these developments mean for
the cyber-security industry? For one, that security is no longer merely 5,000

a concern of IT managers, but a key boardroom topic as enter-

4,000
prises have to recognize its strategic importance. Companies need
to beef up their security infrastructure to prevent breaches. Various 3,000

regulations like the US's NIST framework and the EU Cyber Security 2,000
framework mandate minimum cyber-security standards. Financial
institutions, for instance, face hefty fines if they do not comply with 1,000

them. Interestingly, regulators themselves are not isolated from the 0

wave of cyber-security spending. The rising risks around data also Facebook Amazon Microsoft Alphabet Total

mean that major internet platforms globally continue to boost R&D 2016 2017

spending on security (Fig.4). With regulations on internet platforms, Source: Company reports, Bloomberg Intelligence, UBS, as
including the upcoming implementation of GDPR (General Data Reg- of April 2018
ulation Protection) in Europe, spending on security should remain in
focus. Fig. 5: Global security software spending
breakdown by segment
The size of the global market was USD 100bn in 2015, and has grown Web security
by around 8% annually the past two years. Improving global prof- Messaging 5.6%
security
itability and a pickup in enterprise IT spending should expand the end- 5.9% Network
market by 8-10% annually on average over the next two years, with security
30.5%
the addressable market potentially reaching USD 150-160bn by the Security &
Vulnerability
end of 2020. These estimates look reasonable to us. Cyber-security is 15.5%
also one of the most defensive segments within IT; spending on it has
limited downside due to its importance, and has increased at a high-
single-digit rate in recent years, at a time when broader enterprise IT
spending limped along at low single digit rates.
Identity &
The security market is broadly divided into six segments: network Access mgt
security, end-point security, identity and access management, security 15.8% End-point
and vulnerability management, messaging security, and web security. security
26.7%
As is the case with any IT industry, cyber-security is broadly divided into
Source: IDC, Bloomberg Intelligence, UBS, as of 2015
three major components: security hardware, software and services.
We see security software as a clear stand-out within the cyber-security
market given its above-average growth prospects, solid margins and
high recurring revenue base. The size of the industry stood at USD
34bn in 2015 (see Fig. 5), according to IDC and Bloomberg Intelli-
gence data, and we expect it to reach USD 50bn by 2020.

Chief Investment Office Americas, Wealth Management 19 April 2018 3

Longer Term Investments

Fig. 6: TIC market by country

Testing, inspection & certification (TIC) Japan
Companies in the TIC sector ensure that products and processes meet South Korea 6% Others
3%
standards and regulatory requirements in terms of safety and perfor- 19%

mance. They serve different end-markets, including the automotive,

consumer, environmental, food, medical, life sciences, and oil & gas
sectors, and inspect, verify, test, and certify services against pre-spec-
China
ified standards. 30%
US
We estimate the addressable TIC market to be worth more than EUR 17%

200bn. This figure is based on an analysis done by Bureau Veritas, a

global market leader, and includes in-house and outsourced services. Brazil
The market opportunity for public and private companies is more than India 2%
3%
EUR 80bn; the rest is for government and insourced services. The EU
20%
regional and end-market split shows a lack of concentration (see Figs.
6 and 7), which makes it an attractive business model as there is no Source: Bureau Veritas as of 6 October 2015
dependence on a single region or market.
For the 20 years ending in 2014, the average annual market growth Fig. 7: TIC market by industry
Based on EUR 200bn market size
rate for TIC was almost 9%, which beat nominal GDP growth by 2
Financial
percentage points p.a. In recent years, oil & gas headwinds have hin- Marine
Healthcare
3%
institutions
Others
2%
Consumer goods
(hard-/softlines)
2%
dered it, but we think that the TIC rate will continue to outpace GDP 3% 12%
Government
growth thanks to attractive end-markets and further market consoli- services
3% Food & Agri
dation longer term (TIC market growth rates by UBS estimates: -0.8% Power generation
12%

in 2016 due to the drop in oil & gas investments, +2.5% in 2017, 6%
Automotive
+3.5% in 2018e and +4.9% in 2019e). 7%
Oil & Gas
The growing EM middle class wants more consumer goods (e.g. appli- Transportation (rail 10%
+ planes)
ances, clothes) that will require more TIC services. Asia-Pacific's robust 7%

demand for cars and the growing construction market in important Machinery Construction
8% 10%
developed markets should boost growth as both the automotive and Mining
Chemicals
construction sectors are heavy users of TIC company products and 9%
10%

services. A major end-market is the environmental sector, which ben-

efits from trends, such as water scarcity, clean air, and EM waste man- Source: Bureau Veritas as of 6 October 2015
agement and recycling, as discussed in three of our previous Longer
Term Investment Themes. Fig. 8: Revenue breakdown by region last year
In USD million (estimates)
The individual market drivers include increasing consumer awareness
7,000
about the quality and safety of products (as evidenced by the baby
food scandal in China) and tighter regulations and standards in the 6,000

environmental, food and healthcare sectors. Many companies use 5,000

supplier and client certifications to maintain or improve their repu- 4,000
tation. EM companies in particular often still lack global certification,
3,000
a situation that we expect will change (we anticipate them seeking
more ISO certificates). Companies aren't the only entities that want 2,000

to adapt to these standards; government regulation often requires 1,000

products to be certified by independent third parties (toy testing, for
0
instance, has been compulsory in the US since 2008). SGS Bureau Veritas Intertek
EMEA Americas APAC
Another trend is to reduce costs by outsourcing testing services in
Source: FactSet as of April 2018, UBS Note: EMEA =
favor of external expertise that uses state-of-the-art equipment. A
Europe, Middle East, Africa
growing industrial base in China and India should also spur demand
for TIC services. Energy-efficiency and other requirements are getting
tougher and require certifications.
The TIC industry is fragmented. The market share of the top 15 com-
panies is only 40%, with the rest of it split among niche players with

Chief Investment Office Americas, Wealth Management 19 April 2018 4

Longer Term Investments

revenues of less than USD 10m annually. The top three players are
SGS, Bureau Veritas and Intertek, whose sales range between USD
3bn and >6bn (see Fig. 8). SGS operates more than 2,400 offices and
laboratories globally. The top 10 companies are all European, with
five non-listed companies (Dekra, TUV Süd, DNV, TUV Rheinland, and
Lloyd's Register) among them. The sector has been one of the most
active in M&A.
Fig. 9: The life science tools market by product
Life science tools segment
Security and safety also encompasses the safe development of new Microscopy & Mass spectrometry General analytical
surface analysis 3%
drugs and the testing of water, soil and air quality. Life science Materials testing &
3% tools
2%

tools (LST) companies that offer products satisfying these challenges characterisation
4%

can benefit from greater safety requirements. LST companies sell Lab automation
4%
Molecular &
cellular biology
equipment used in laboratories and research centers to test and Lab equipment
4%
tools & reagents
34%
monitor products prior to their sale and provide information about Atomic
spectrometry
things like water quality. This equipment includes incubators and 4%

freezers, consumables like glassware, microscopes and pipettes, and Molecular

spectroscopy
laboratory reagents and software. UBS estimates the size of the LST 7%

market at more than USD 100bn annually (see Fig. 9). Historically, Chromatography
7% Diagnostic &
LST firms have organically increased revenue slightly more than global General laboratory clinical supply
19%
disposables
GDP, and their margins have grown at a faster clip than the average 9%

S&P 500 company. We expect the sub-sector to expand in line with

Source: Based on Merrill Lynch as of April 2018
global GDP rates now that it is at a more mature stage. Margins should
still exceed the broader market's given ongoing consolidation, oper-
ating leverage and pricing power above inflation.
Though LST companies are expanding more slowly than other security
ones, their stock belongs in a well-diversified security portfolio, as
the breadth of the sector's customers (200,000 laboratories and
100,000 customers) lends it defensive qualities. LST companies com-
monly supply the biopharma and food and pharma-testing markets
(testing, inspection and certification companies are typical customers).
The sector is characterized by high barriers to entry and a stable
business model; since customers don't buy products from unproven
vendors, it offers earnings stability and visibility. The long-term growth
drivers, such as protecting the global food chain and the environment
(e.g. water control), combatting hospital infections, assisting forensic
labs involved with criminal cases and testing children's toys, etc., are
similar to those in the TIC sector.

Commercial & residential construction

Alongside cyber-security, commercial and residential construction
security is one of the largest theme sub-sectors, with an array of
products and services on offer. Assa Abloy, the market leader for locks
and security systems, estimated a few years ago that the total security
market is worth over EUR 250bn. It focuses on electromechanical
and mechanical locks as well as security doors. We exclude some
services (guards) in our definition of the sector and so assign it a
smaller overall market size (EUR 200bn / USD 250bn, see Fig. 15).
From a regional perspective, the highest growth rates are in EM. Africa
and the Middle East remain particularly underdeveloped, though big
markets like China and India should also grow at brisk rates. The build-
out of new infrastructure and buildings in big cities (urbanization)
fuels demand.

Chief Investment Office Americas, Wealth Management 19 April 2018 5

Longer Term Investments

In addition to this underlying demand growth, consolidation (e.g.

Assa Abloy has acquired an average of 5-10 companies annually) will
increase revenue and earnings, in our view. The desire for greater res-
idential security has historically sold security products.
Data from 2010 shows that an American household was burglarized Fig. 10: Plunging total crime rates in the US
every 13 seconds (based on crime statistics). One in three houses Both in millions
without an alarm system suffered a break-in or break-in attempt, 12.5 330

while only one in 250 houses with an alarm system did. Another study 12 320

analyzed the average loss from burglary, finding that in homes with an 11.5 310

alarm system it is only USD 3,266 versus USD 5,343 in those without 11 300

one (based on data gathered from Greenwich, CT), because an alarm 10.5 290

system gives burglars less time to spend in each house. 10 280

9.5 270
Better protection is also reflected in lower crime rates, which have
9 260
sunk over the last decade (see Fig. 10). This is even more impressive 2001 2003 2005 2007 2009 2011 2013 2015
given the rising population. These dynamics are expressed in the fact
Total number of crimes (lhs) US population (rhs)
that the market for electromechanical security products expanded
3-4x faster than the traditional mechanical lock market in the last 10 Source: US Disaster Center, as of March 2018 Note: rhs =
years. A nice side effect of better home security is a lower insurance right hand side; lhs = left hand side
premium, which creates additional incentives for investment. We
expect major business opportunities in EMs as their middle class con- Fig. 11: US residential building fires and deaths
tinues to grow. Typical home security products are electric locks, 400 3,150

sensors and cameras. The rising awareness of the need for energy-effi- 390 3,050

cient applications (smart homes) enhances growth potential as well. 380

2,950

2,850
Ongoing urbanization and a larger EM middle class also support the 370
2,750
commercial and residential construction safety market. As the number 360
2,650
of people who can afford security services grows, and as they tend 350
2,550
to live in higher-density neighborhoods, demand for them should 340 2,450
rise. Also, emerging and developed markets alike exhibit a greater 330 2,350
need for security investment in infrastructure like airports (e.g. for bio- 2003 2005 2007 2009 2011 2013 2015

metrics). Another trend prevalent in developed countries stems from Residential Building Fires (in 1,000)
renovation: many older houses have no fire safety equipment. Last Residential Building Fire Deaths (rhs)

but not least, better technology and, with it, more outsourcing (e.g.
Source: U.S. Fire Administration, National Fire Protection
remote monitoring, video surveillance) benefit companies active in Association, as of March 2018. Note: rhs = right hand side
this market.
Other promising trends in the commercial and residential construction
area include access control, home security solutions, video surveil-
lance and fire protection. With regard to access control, biometrics
represents one of the highest-growth segments, given the increasing
importance of identity security (for travel documents, identification
cards, healthcare cards and drivers licenses). Similar strong demand
is expected in the video surveillance market, which is fueled by the
need to support public safety in light of terrorist threats and everyday
crime, which is translating into higher spending by governments and
the private sector alike. Finally, the fire security market is worthy of
mention. At present, North America and Europe are still its largest
markets, but Asia is catching up quickly.
Tighter regulation, construction activity and asset protection are the
most important factors with regard to fire security. Many countries
have laws in place that ensure the use of alert systems in old and new
buildings (e.g. US National Fire Protection Act or the European Norm).
According to the National Fire Protection Association, reported home

Chief Investment Office Americas, Wealth Management 19 April 2018 6

Longer Term Investments

fires were 50% lower in 2014 than in 1980, and fire deaths were
down 47% (see also Fig. 11). US fire deaths have been relatively stable
despite a growing population because of, among other factors, more
fire alarms. But almost two-thirds of fire deaths still occur in buildings
without fire alarms or with non-functioning alarms, sad statistics that
clearly support our investment theme.

Risks
Risks in the cyber-security area include the inability of security vendors
to prepare for a major threat or to adjust to a major technological
change, which would result in lower spending. A weaker macro
outlook could also weigh on enterprise and government IT outlays,
though we believe cyber-security should be relatively less affected,
as evidenced by the US's FY 2017 budget. In the other sub-sectors,
a main risk comes from the regulatory side. Less strict regulation
might lessen demand for TICs and construction-exposed names,
reducing expected sales and earnings growth. Decreased government
spending on critical infrastructure (airports, public places, etc.) would
also reduce investment in security products. TIC companies have a
broad range of end-markets, and weak demand in areas not discussed
in this report (e.g. the oil & gas end-market) also jeopardizes sales and
earnings. In the life science and tools sub-sector, the biggest risks are
again regulatory changes and reimbursement uncertainties.

Link to sustainable investing

We view "Security and safety" as a sustainability-themed investment
that fits in our sustainable investing (SI) framework. The products
and services offered by security and safety companies apply primarily
to the social aspects of environmental, social and governance (ESG)
issues. In particular, cyber security issues have gained importance in
recent years as sector products address the need to prevent data
loss. Breaches of cyber security may damage society because they
can disrupt the financial system, food and water provisioning, and
communications. Traditional risks that security and safety companies
address are found in the area of testing: assessing the quality of the
global food supply chain, monitoring water, soil and air quality, and
testing children's toys for toxic heavy metals. The security and safety
companies either operate the laboratories that conduct this testing or
provide equipment to them. Other examples include building security,
such as fire detection.

Chief Investment Office Americas, Wealth Management 19 April 2018 7

Longer Term Investments

Conclusion Fig. 12: Security and safety addressable market

In USD billions
The importance of the security and safety industry should keep its 350
products and services in high demand. While it should generally
300
benefit from a pickup in the global economy, spending on it tends
250
to exhibit less cyclicality, which makes the theme more defensive. As
200
seen in Fig. 15, our bottom-up estimates project that the addressable
150
market should increase by an average of 6% over the next few years.
100
Though it is already a large industry (estimated size around USD
50
600bn in 2017), we believe its growth rates will remain impressive.
0
More importantly, its earnings growth should reach high-single digits Cyber Comm & Resi Con Testing Inspection Life Science Tools
Certification
and low double-digit rates, given the margin expansion resulting from
2017E 2020E
an improving mix as the share of higher-margin businesses increases.
Source: Industry and company reports, UBS estimates
To fully benefit from this theme, investors need to take a long-term
(based on EUR/USD exchange rate of 1.1) Note: Cyber =
view. Companies that make up the theme, particularly those in the Cyber-security; Comm & Resi Con = Commercial & Resi-
cyber-security sub-sector, feature solid balance sheets and strong cash dential Construction
flow generation. The other sub-sectors are also characterized by solid
structural growth trends, such as the rising demand for testing in
EMs and the greater need for commercial and residential construction
security applications.

Chief Investment Office Americas, Wealth Management 19 April 2018 8

Longer Term Investments

Appendix

Terms and Abbreviations

Term / Abbreviation Description / Definition Term / Abbreviation Description / Definition
2011E, 2012E, etc. 2011 estimate, 2012 estimate, etc. A actual i.e. 2010A
COM Common shares E expected i.e. 2011E
FY Fiscal year / financial year GDP Gross domestic product
p.a. Per annum (per year) Shares o/s Shares outstanding
UP Underperform: The stock is expected to CIO UBS WM Chief Investment Office
underperform the sector benchmark
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Chief Investment Office Americas, Wealth Management 19 April 2018 9