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Winter 2018

A Spotlight on Semiconductors and Highlights from other Sectors

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Welcome to the Janus Henderson Investors Global Sector Views, where our analysts share insights on the six sectors they follow. Also included is an in-depth analysis of key trends in a single sector or industry, with this quarter focusing on how new demand sources and industry consolidation are benefiting semiconductors. In addition, we cast a spotlight on the contributors to the piece: who they are, how they analyze stocks and bonds, and a bit about their lives outside the office. We invite you to explore these views on the following pages.

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NSector Overview 2

Technology

Consumer

Energy & Utilities

Financials

Health Care

Industrials & Materials

Sector Spotlight 5

Technology: Semiconductors

Contributor Profiles 10

Technology

Opportunities in SemiconductorsCompanies are increasingly moving workloads from physical servers to the cloud and deploying programs such as Software as a Service. This has resulted in impressive growth rates for industry leaders. We’re also seeing acceleration in the development of the Internet of Things, mobile connectivity and artificial intelligence. Investments in these technologies are significant, especially in China, where digital payments and e-commerce are rising rapidly, benefiting Chinese companies with leading tech platforms.

Such trends are driving growth in the technology sector, including semiconductors. For more detail about the opportunities and potential pitfalls for semiconductor companies today, please read our sector spotlight starting on p. 5.

Consumer

Shifting Media LandscapeThe pay-TV market has been in decline since mid-2012. One culprit is weak household formation, measured by the number of occupied housing units in the U.S. This figure rose by just 0.3% in the year through September, which is the slowest rate of growth since 2010. Also impacting the industry is the rising number of households that are “cutting the cord” or simply never subscribing to pay-TV. Over-the-top (OTT) video packages (media transmitted via the Internet as a standalone product, like Netflix) continue to see strong growth, doubling their market share in the most recent quarter, while traditional media continues to fall.

Equity Investment ImplicationsNo matter how strong pricing remains or what long-term carriage agreements are in place, we believe no industry can sustain the type of volume losses being experienced by traditional TV. Internet distribution and mobility are creating new ways for media to be consumed and therefore challenging the traditional TV business model. We are focusing on companies that can successfully navigate this disruption.

Fixed Income Investment ImplicationsThe proliferation of digital streaming services is impeding subscriber growth for cable and video providers and forcing many investment-grade media companies to consolidate. We are cautious on the media space given the uncertain outcomes of numerous potential mergers and acquisitions, as well as weak fundamentals and disintermediation in the sector. We appreciate OTT companies that are benefiting from consumers trending toward digital.SE

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Energy & Utilities

OPEC Delivering on Production CutsOil prices have benefited from production-cut discipline among members of the Organization of the Petroleum Exporting Countries (OPEC): Daily production has fallen by 4.5% since November 2016, and the cartel recently voted to extend cuts through the end of 2018. Improving fundamentals in the U.S. have also contributed to a more bullish outlook, as inventories have fallen by more than 14% since March. Recently, the price per barrel of Brent Blend, the global benchmark, eclipsed $60 for the first time in nearly two years.

Equity Investment ImplicationsWe continue to focus on names with a business model or stock-specific catalyst that isn’t a binary call on crude oil prices. We favor high-quality exploration and production companies that are well positioned on the global cost curve. Should North American production growth continue to be strong, we favor midstream names with infrastructure accessing the Permian and other attractive oil fields.

Fixed Income Investment ImplicationsWe favor companies with high-quality assets, capable managers, a good liquidity runway and near-term deleveraging catalysts. We are also looking for names with a strong margin of safety in bond valuation. We believe these issuers are better positioned to succeed in varying oil price environments.

Financials

Potential Benefits from Tax CutsTax reform in the U.S. could benefit the sector, as a lower corporate tax rate would likely boost the earnings of financial companies and potentially spur economic growth (increasing demand for loans and supporting the case for higher interest rates). Financials could also benefit from continued loosening of regulation and the sector’s increased investment in technology.

Equity Investment ImplicationsWe continue to like financial stocks exposed to structural growth opportunities. For example, within the payments industry, we’re witnessing a trend of customers increasingly moving to digital payments. Mega banks are capitalizing on this by shifting their focus from bank branches to digital offerings. Given that these banks tend to have more consumer data and better digital applications, we believe there will be an organic share shift to mega banks.

Fixed Income Investment ImplicationsWe expect U.S. banks to profit from rising interest rates. Regulatory rollbacks, if executed thoughtfully, could improve the earnings and therefore credit profiles of these companies. However, we are mindful that an excessive loosening of regulations could reverse creditor-friendly directives implemented in the wake of the financial crisis.

Health Care

Long-Term Growth OpportunitiesDespite the sector’s recent volatility, we believe significant growth opportunities remain. The Food and Drug Administration (FDA) approved more than 40 new therapies in 2017, compared to 22 in 2016. The large number of approvals reflects the FDA’s commitment to bringing treatments to patients with high, unmet medical needs and the growing number of biotechnology companies focused on innovation. Also, pharmaceutical companies with offshore cash balances could benefit from U.S. tax reform lowering tax rates on repatriated savings. Longer term, rising health care costs and regulatory changes could affect utilization and drive market competition, but we think an aging population and new technology should support demand.

Equity Investment ImplicationsWe remain committed to identifying innovative companies addressing high, unmet medical needs. The FDA has approved the first gene therapy in the U.S., and we anticipate results from key immuno-oncology (IO) trials in 2018. If positive, these trial results could benefit certain pharmaceutical companies and give clarity on possible market expansion for IO therapies.

Fixed Income Investment ImplicationsWhile pharmaceutical companies have focused on small transactions to boost their drug pipelines, we could see plans for larger merger-and-acquisition activity as companies get clarity on tax reform. We are identifying opportunities in firms that are allocating capital to reduce leverage after engaging in debt-funded acquisitions. We are avoiding names in need of a more robust drug pipeline that are likely to increase leverage to obtain it.

Industrials & Materials

A Stronger Economy Drives GrowthThe stabilization in commodities, currencies and global measures of manufacturing strength are providing a nice backdrop for better industrial growth. In the U.S., the Institute for Supply Management’s Purchasing Managers’ Index (PMI) – a monthly measure of manufacturing strength – has remained solidly in expansionary territory since September 2016, and the PMI for the eurozone recently hit its highest level in more than six years. We believe this growth should continue, barring any exogenous shocks. One potential area of concern is opacity in forecasting the public spending piece of infrastructure, which could impact some materials companies.

Equity Investment ImplicationsWe continue to focus on company-specific drivers of value, such as opportunities for margin expansion, as well as management teams with a track record of superior capital allocation and ample cash to deploy. These factors tend to determine outperformance regardless of the economic environment.

Fixed Income Investment ImplicationsLow unemployment rates and tight housing stocks have encouraged homeowners to spend on renovations, which is benefiting industries such as homebuilders and construction materials. We also appreciate that management teams are being disciplined as they think through the business cycle. In the construction aggregate space, for example, management teams looking for growth are doing so by conducting smaller acquisitions, taking on less debt and deleveraging quickly.

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For years, semiconductor firms were tied to PC and smartphone product cycles. As new products were released, the companies that made the integrated circuits – or semiconductors – found in these and other electronic devices would scramble to take share by cutting prices and expanding capacity, sowing the seeds for a sharp downturn when demand cooled. It was the quintessential cyclical industry.

Now, this boom-bust pattern could be diminishing. For 2017, semiconductor revenue is forecast to rise by nearly 20% to $411 billion globally, the largest annual jump since 2010, according to Gartner, a research firm. An explosion in demand for semiconductor content is helping drive those sales. But instead of cutting prices and revving up production, as in the past, the semi industry is taking a more rational approach. “Companies are talking about engineering a soft landing from a few quarters of pretty strong performance,” says Jon Bathgate, CFA, Research Analyst and Co-Sector Head of the U.S.-based equity Technology team. “That is a change in thinking.” It could also be part of a broader opportunity in semis for both stock and bond investors.

The Challenge of Moore’s LawLike many industries today, semiconductors are hitting an inflection point, Mr. Bathgate says. For decades, companies had been guided by Moore’s law, which, in simple terms, states that computer processing power doubles every two years. But higher processing speeds have been achieved by making transistors on integrated circuits (or chips) infinitesimally small. At the same time, advanced technologies such as artificial intelligence (AI) require ever-more computing power. As such, doubts are growing as to whether Moore’s law can continue without costs rising astronomically. These questions have forced companies to develop new architectures outside of central processing units (CPU), the digital chips that have long been the engine of computing. “For the first time ever, firms are saying we need specialized processors to meet this challenge,” Mr. Bathgate says.

CPU leader Intel, for example, is broadening its toolkit. In 2015, the company acquired Altera, which makes field-programmable gate arrays, chips that can be programmed after they are built. Then, a year later, Intel bought Nervana Systems, a startup that specializes in the machine learning systems critical for AI applications. Even companies such as Alphabet (the parent firm of Google) are dabbling in semis: When the tech titan needed more computing power to run services such as voice recognition, Google designed the tensor processing unit (TPU), a circuit built specifically for machine learning. TPUs accelerate the work of traditional processors and, as a result, saved Google from having to double its network of data centers to achieve similar computing power.

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Companies are talking about engineering a soft landing from a few quarters of pretty strong performance. That is a change in thinking.” Jon Bathgate, CFA, Research Analyst

New End MarketsAn explosion of new end markets is also driving innovation. While PCs and smartphones still account for most semiconductor sales, other segments are catching up thanks to the Internet of Things (IoT), cloud computing, mobile connectivity and AI. Automobiles, for example, are projected to become a significant source of demand as vehicles are increasingly built with advanced driver-assistance systems, which rely on a multitude of sensors and integrated circuits. Long term, the electrification of cars will also play a role. Today, conventional autos include about $330 in semiconductor content, but electric vehicles contain more than $1,000. Similar shifts in automation and electrification are occurring in factories, commercial aircraft and fighter jets.

New Demand for SemiconductorsPCs and smartphones have traditionally dominated semiconductor sales, but other end markets are growing.

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Source: 2015 and 2016 “Semiconductor End-Use Reports,” World Semiconductor Trade StatisticsNotes: Total sales were $335 billion in 2015, and $339 billion in 2016.

Even mundane objects are increasingly built with semis. The advent of IoT and increased connectivity has led to a multitude of “smart” products, from windshield wipers that turn on automatically during rainstorms to refrigerators that update shopping lists when internal cameras spot that supplies are running low. Much of this technology would be impossible without analog chips, which collect real world signals (such as the presence of raindrops), and microcontrollers, a type of minicomputer that executes specific tasks. The opportunity is substantial: Texas Instruments, the largest player in analog, commands only about a quarter of the market. Even then, says Mr. Bathgate, “We believe Texas Instruments can grow by 5% to 10% annually for the next 20 years and still have opportunities for additional growth.”

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Addison Maier, a U.S.-based Fixed Income Analyst covering the technology sector, says the wider breadth of demand sources is making the industry more attractive for bond investors. “The diversification in end uses puts many of these companies in a better position to service debt, even if they hit a downside scenario,” he says. He points to Microsemi Corporation as one case. The firm designs and manufactures circuits used in aerospace and defense, communications, data centers, and industrials. Even when some end markets have been sluggish – a spending slowdown in China weighed on Microsemi’s communications revenues during a recent quarter – other segments have delivered robust growth. As a result, Microsemi’s overall sales climbed by 9.5% for the fiscal year that ended October 1.

ConsolidationTraditionally, the semiconductor market was highly fragmented. But a prolonged downturn, rising costs and record-low interest rates have prompted a wave of consolidation. The net result is a rationalized market, with many management teams focused on sustained growth. “A lot of teams are more seasoned,” Mr. Bathgate says. “They’ve been through cycles and know not to get over their skis when things are really good.” Micron Technology, for example, is one of only three key players in the DRAM memory market, down from half a dozen a few years ago. In September, the firm told investors that it plans to make $7.5 billion in capital expenditures (capex) in 2018. Although the figure was ahead of consensus estimates of $5 billion to $6 billion, it is still well within expectations for the company’s future revenue growth. “Micron has no ambitions to outgrow the market, even with this elevated capex,” Mr. Bathgate says. He adds: “It feels like we are in somewhat of a Goldilocks environment, in which elevated capex no longer signals the peak of the cycle.”

Mergers & AcquisitionsThe semiconductor industry is consolidating, with the total value of announced deals rising each year.

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The diversification in end uses puts many of these companies in a better position to service debt, even if they hit a downside scenario.” Addison Maier, Fixed Income Analyst

Mergers and acquisitions are driving up debt levels in an industry that historically has issued few bonds. But many companies now have greater scale, improving their standing with credit rating agencies. Also, deals tend to be highly complementary, says Mr. Maier, helping acquisitive companies gain access to new end markets or realize significant cost synergies. In turn, free cash flows are climbing and semiconductors are deleveraging balance sheets quickly, creating attractive opportunities for bond investors. For example, roughly a year after completing an acquisition in 2016, ON Semiconductor’s net leverage ratio dropped from 3.2 to 2 times, a year ahead of schedule. “Semiconductor companies know they’re still in somewhat of a cyclical business,” Mr. Maier says. “Once they lever up, they don’t want to sit at that level for too long.” Rising free cash flow has also benefited equity investors, as firms buy back shares and pay dividends. “This has brought a lot of new investors into the sector,” Mr. Bathgate says.

Semiconductor Firms Generate More Free Cash Flow as Revenues Rise

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Notes: *Estimated. Data are an aggregate of the five largest companies by market capitalization in the PHLX Semiconductor Sector Index: Taiwan Semiconductor, Intel, NVIDIA, Broadcom and Qualcomm.

Smoother Business CyclesThe flood of investors is reflected in the industry’s strong performance of late. From the start of 2017 through November, the Philadelphia Stock Exchange (PHLX) Semiconductor Sector Index, a market capitalization-weighted benchmark of 30 semiconductor companies, returned 42.6%, compared with 20.5% for the S&P 500 Index®. This is causing some to question whether the boom in semis can last, as evidenced by recent volatility in the stocks. A number of semiconductor leaders have significant exposure to heady markets, such as cryptocurrency, and it’s still not clear what the winning architecture will be in emerging technologies, such as autonomous vehicles and AI.

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Still, Mr. Bathgate and Mr. Maier say that while a correction is possible, they believe consolidation and secular growth drivers will help make cyclical swings less drastic. They argue any pullback should be limited to a quarter or two. And long term, the analysts expect semis to deliver mid to high single-digit growth, roughly twice the rate of projected U.S. economic expansion. Also, rather than try to forecast which company will power, say, the self-driving car of the future, Mr. Bathgate says companies such as ASML, Cadence Design Systems and Lam Research, which sell the equipment and software needed to fabricate chips, are well positioned. “We don’t know which architecture will win in 10 years, but we’re pretty confident that these companies will provide the tools,” Mr. Bathgate says. Mr. Maier agrees, pointing to Cadence, as well as Taiwan Semiconductor, a global chip manufacturer.

Furthermore, even as semiconductor stocks have outperformed, valuations remain near the industry’s five-year historical median. Investors wary of semiconductors’ cyclicality could be overlooking potential catalysts, Mr. Bathgate says. Cloud computing and AI, for example, are memory-intensive applications, to the point that traditional applications, such as PCs and enterprise servers, are starting to see memory shortages. Such supply/demand dynamics could benefit ASML and Lam Research, which rely on the memory industry for customers. In addition, investors may not appreciate the new diversity of end markets, including aerospace and defense, Mr. Maier says. “You could see a scenario today where defense spending grows above expectations,” he says. “That is an attractive optionality for semiconductor firms.”

Semiconductor Stocks Still Attractively ValuedStock prices for semis have climbed, but so have expectations about future earnings. As a result, the group’s forward P/E ratio remains near the five-year historical median.

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Notes: Data based on PHLX Semiconductor Sector Index. EPS = earnings per share. Expected EPS is forward 12-month estimate. Price appreciation and expected EPS growth indexed to 100 as of 11/30/12.

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Jon Bathgate, CFAResearch Analyst

What is your favored metric for analyzing a stock? Free cash flow and the growth of free cash flow. At the end of the day, the value of any business we analyze is driven by the cash a company generates. Free cash flow also normalizes for different approaches to accounting, which is important in the tech sector, given widely used non-GAAP accounting practices. Businesses that generate strong free cash flow also tend to be able to weather an economic downturn.

Talk to us about the formative experiences of your career or how you got started in the industry. Early in my career, my coverage included industries that were significantly overhyped, notably renewable energy and 3-D printing. Some companies saw their stocks go down 80% to 90%, or even went bankrupt. The experience drove home the importance of being focused on fundamentals, cash generation and high-quality businesses, rather than chasing the next big thing.

What are you passionate about outside the office? Anything outdoors, as well as spending time with my wife and our 1-year-old son.

Addison MaierFixed Income Analyst

What is your favored metric for analyzing a bond? Debt-to-enterprise value, which measures how much debt there is relative to the total value of a business. The ratio is important because it provides insight into a company’s ability to service its debt, as well as how much cushion you have as a creditor before your bonds could be impaired.

Talk to us about the formative experiences of your career or how you got started in the industry. Being an intern in the Janus Fixed Income group in 2010 and 2011, as the European sovereign debt crisis was heating up. The experience gave me early perspective on how interconnected the markets are and what downside can really look like.

What are you passionate about outside the office? Family and exercise. Luckily, my wife teaches yoga, so sometimes I can kill two birds with one stone.

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For more information, please visit janushenderson.com.

The views presented are as of the date published. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. No forecasts can be guaranteed. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission.Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.Janus Henderson is a trademark of Janus Henderson Investors. © Janus Henderson Investors. The name Janus Henderson Investors includes HGI Group Limited, Henderson Global Investors (Brand Management) Sarl and Janus International Holding LLC.FOR MORE INFORMATION CONTACT JANUS HENDERSON INVESTORS 151 Detroit Street, Denver, CO 80206 | www.janushenderson.com

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