27 February 2014

CIO WM Research

US Equities Information Technology Secular growth, on sale • We continue to believe that the Technology sector is positioned to outperform the broader US equity market as both earnings and sector valuations rebound. • Since 30 June 2013, the Technology sector has outperformed the S&P 500 by more than 6 percentage points, rising 23% versus the 17% market gain. However, relative valuations remain attractive with the sector still trading at a 3% discount to the market compared to its average 15% P/E premium over the past 10 years. • Tech earnings decelerated last year, growing just 2%. Declining PC unit growth, weak enterprise spending and disappointing results for Apple weighed on the bottom line. But the full-year weakness was “front-end loaded” and an earnings rebound has already become evident over the past two quarters. • Importantly, the earnings rebound should continue in 2014; global enterprise spending is improving, PC unit demand has become “less bad” and cash-rich companies will continue to execute share buybacks to significantly boost earnings per share.

Jeremy Zirin, CFA, strategist, UBS FS [email protected], +1 212 713 1219 David Lefkowitz, CFA, strategist, UBS FS [email protected], +1 212 713 3739 Bob Faulkner, analyst, UBS FS [email protected], +1 212 713 3720 Matthew Baredes, strategist, UBS FS [email protected], +1 212 713 2812

For specific stock recommendations, please see the latest US Equities Information Technology monthly report by Bob Faulkner and George Lambertson.

Fig. 1: Tech earnings growing once again Year-over-year Tech sector earnings growth 25% 20% 15% 10% 5% 0% 2014

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Tech momentum building After a difficult period from April 2012 to April 2013, the Tech sector has staged a nice rebound. Since 30 June 2013 the sector has outperformed the S&P 500 by more than 6 percentage points, rising 23% versus the 17% market gain. With sector earnings rebounding, valuation still very attractive and cash distributions to shareholders likely to remain robust, we believe the Technology sector will continue to outperform in 2014.

Note: Brown bar represents CIO WMR estimates Source:FactSet, UBS CIO WMR, as of 25 February 2014

Earnings reaccelerating In our view the most significant driver of the rebound in the Tech sector has been the improvement in earnings. As we show in Fig. 1, Tech sector earnings growth rates decelerated in 2012 and dipped into negative territory in the first and second quarter of 2013. But Tech earnings have rebounded over the last two quarters and we expect this trend to continue. The late 2012/early 2013 earnings slump was attributable to two drivers: enterprise spending weakness and Apple.

This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on page 7. 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. UBSFS accepts responsibility for the contents of this report. U.S. persons who receive this report and wish to effect any transactions in any security discussed in this report should do so with UBSFS and not UBS AG.

US Equities Information Technology

After a period of retrenchment… Enterprise spending accounts for the lion's share of Tech revenues. And US Tech companies often dominate their markets globally. So it should not come as a surprise that Tech sector earnings growth began to slow just as Europe entered recession in mid-2011 and European corporate profits began to contract. With Europe now climbing out of recession, modest positive growth in this region should provide a tailwind for the sector. The political change-over and a re-orienting of economic policies in China also contributed to the sluggish earnings environment. US companies also pulled back on investment during this period, which also coincided with the intensification of the US federal government budget battles. As we show in Fig 2, core capital goods orders slumped throughout 2012 and then broke into positive territory in mid-2013 (abnormal weather likely drove the most recent dip). We estimate that technology spending accounts for roughly one third of corporate capital investment. …enterprise spending outlook improving We believe the outlook for continued improvements in capital spending is bright. As can also be seen in Fig 2, corporate capital spending plans as measured by the Philadelphia Fed survey remain firmly in expansion territory, a good leading indicator for overall capital spending. Furthermore banks continue to loosen credit standards for new commercial and industrial loans, providing a supportive financing environment. In prior research we have also shown that the existing stock of corporate capital equipment is the oldest it has been in 50 years, providing additional incentive for businesses to replace equipment. The bottom line is that Tech earnings growth should be supported by an improving US and global corporate spending environment.

Fig. 2: Tech to benefit from improving capital spending intentions, which remain solid Philly Fed capex expectations and Core capital goods orders 40 30 20 10 0 (10) (20) (30) 2005

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Philly Fed capex expectations Core capital goods orders, y/y % change

Source: FactSet, UBS CIO WMR, as of 27 February 2014

Fig. 3: Earnings growth ex-Apple has improved Technology sector earnings growth, excluding Apple 25% 20% 15% 10% 5% 0% 2014

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Apple earnings stabilizing It is also worth bearing in mind that Apple accounts for nearly 20% of Tech earnings and the company’s rapid earnings growth deceleration since mid-2012 was also a significant drag on the overall sector. Keep in mind that while the market capitalization weighted Technology sector modestly lagged the S&P 500 in calendar year 2013 by 150 basis points (largely due to Apple), the equal-weight Tech sector index outperformed the equal-weight S&P 500 index by 600 basis points. While Apple's sheer size suggests that it is very unlikely to return to the hyper growth of prior years, its valuation is low, the company seems poised to enter into new product categories and earnings per share should also be supported by a very aggressive share repurchase program. The bottom line is that unlike in 2013, Apple should not be a meaningful drag on sector earnings or sector performance.

Note: Brown bar represents CIO WMR estimates Source: FactSet, UBS CIO WMR, as of 25 February 2014

Solid 4Q results The better earnings environment is also evident in the most recent quarterly reports. For the just completed fourth quarter earnings season, 77% of Tech companies beat earnings expectations by an aggregate of 3.6%. Impressively, the better than expected earnings were driven by a strong revenue performance. Sector revenues came in 1% better than expected with nearly 70% of companies beating sales expectations. Overall, earnings grew 7% during the quarter and

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as we discussed above, we expect growth to accelerate modestly to 10% in 2014. Incremental optimism from Tech management teams Management commentary was generally cautiously optimistic about the outlook for 2014 but the environment remains uneven based on end market and geographic exposure. Most semiconductor companies highlighted lean inventories and improving demand from industrial customers. While personal computer (PC) demand has largely been labeled as "less bad" by most PC-focused tech firms, enterprise demand was a positive surprise in Q4 and IT spending plans for 2014 suggest a modest improvement in growth. Smartphone growth is slowing at the high-end but remains robust as new entry-level phones make their debut. To support this growth, capital spending on IT infrastructure from wireless telecom service providers is expected to increase in 2014. Finally, the push for cloud-based services (particularly software-as-a-service) continues to be a focal point of IT managers. Lastly, web-based advertising is expected to grow 14% in 2014, again taking significant share from traditional media platforms, supporting the earnings for select large-cap software firms such as Google and Facebook.

Fig. 4: Tech relative valuation appears attractive Tech forward P/E relative to the S&P 500 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 0.8

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Source: FactSet, UBS CIO WMR, as of 25 February 2014

There is always "new Tech" replacing "old Tech" Some who are more cautious about the outlook for the Tech sector make the point that the many of the large, legacy Tech companies are facing technology transitions that threaten their business models. We think this misses the point. It is true that the Tech sector is one of the most dynamic in the market, and is often upended by disruptive innovation that creates winners and losers. But investors who invest at the sector level will gain increasing exposure to the winners and diminishing exposure to the losers. For example, over the last decade, the PC-centric companies have shrunk in market value at the same time that companies that dominate mobility, cloud, and social networks have grown. Still, as we show in Fig 7, the Tech sector posted the fastest earnings growth in the market over this period, and the sector benchmark outperformed, rising 10.3% annually versus a 9.2% annual gain for the S&P 500. This underscores that technology transitions typically do not impair returns at the sector level. And in our view, current valuations do not account for what will likely be very substantial growth for many years to come from the new crop of technology companies that are poised to benefit from these secular growth opportunities. Valuation remains compelling The sector's outperformance over the last several months has resulted in only modest valuation expansion and Tech still remains quite attractively valued, in our view. The sector trades at a forward P/E multiple of 15x, almost exactly in line with the S&P 500. Except for several months in early 2013, this is the Tech sector's lowest relative valuation since the early 1990s (Fig. 4). To put valuation in more recent context, the group has traded at an average relative P/E premium of 15% to the market over the last 10 years, suggesting there is ample scope for P/E multiples to expand. Valuations look particularly attractive given our earnings growth expectations; we look for sector earnings to expand by 10% in 2014. Furthermore, as we have pointed out in prior research the Tech sector has historically delivered annual gains

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of 18% on average over the next 12 months when it has traded at its current valuation. Fig. 5: Tech has the second highest free cash flow yield Free cash flow divided by market value 10% 8% 6% 4% 2% 0% -2%

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Source: FactSet, UBS CIO WMR, as of 25 February 2014

Fig. 7: Tech offers an attractive combination of earnings growth and stability Annual earnings growth and volatility since 2003

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Cash flow and earnings stability is under-appreciated As a result, Tech sector cash flows have become less volatile over the years. In fact, Tech earnings actually grew on an annual basis in both 2008 and 2009 during the Great Recession, a remarkable statement about the sustainability of cash flows for this "cyclical" sector. And as we show in Fig. 7, the sector posted the fastest earnings growth over the last decade, while at the same time the volatility of the earnings stream was lower than any other cyclical sector, and essentially in line with the overall market. All things being equal, a more stable cash flow stream should garner a higher P/E valuation. Yet, other economically-sensitive S&P 500 sectors trade at higher valuations despite delivering weaker historical earnings growth with higher earnings volatility. In sum, we believe the sector's P/E multiple does not adequately reflect both the strength and the resiliency of the sector's cash flows.

Fig. 6: Migration to software makes Tech sector less volatile Percent of Tech sector market value - software vs. hardware & semiconductors

Tech

Software and services revenue streams tend to be much more stable and predictable whereas hardware sales are typically far more "lumpy" from quarter to quarter (and often contract considerably during downturns as customers forgo upgrading to the latest technology). But even if customers (especially enterprises) are not buying new hardware every year, they still need rights to use the software to run their IT infrastructure. And these days most corporate software sales are not discrete one-time purchases, but instead are annual licensing agreements. This shift has not only reduced earnings volatility, but has also raised profit margins for the sector; operating margins for IT software and services tend to be in the 20-30% range compared to 5-15% for the remainder of the IT sector. The transition to cloud and software-as-a-service (SaaS) moves the software industry even further into the recurring revenue business model.

2014E

Source: FactSet, UBS CIO WMR, as of 25 February 2014

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Tech cyclicality has diminished Over the years, Tech sector revenues have shifted from hardware to software and services (Fig. 6). Think of IBM's transition from a mainframe business to a services company. And even the largest hardware company, Apple, has a very strong presence in software and services (iOS and iTunes). This has been a natural migration as hardware has become more commoditized. But this transition also should have positive implications for sector valuations.

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Shareholder distributions are ramping Tech companies have significantly ramped the pace of share repurchases over the last several quarters, demonstrating that management teams increasingly view current valuations to be low. Tech shares outstanding shrank by 1.7% in 2013, faster than the 1.1% decline for the market overall. Add in the sector's 1.6% dividend yield and Tech's "total yield" (buybacks plus dividends) sums to 3.3%, modestly higher than the market's total yield of 3.1%. With a free cash flow yield of nearly 7% (second only to Telecom, Fig 5) and net cash on the balance sheet that totals 13% of the market value of the sector, there remains ample scope for Tech companies to sustain and grow distributions to shareholders.

Volatility (right)

Source: FactSet and UBS CIO WMR as of 26 February 2014

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Bottom line: cheapest cyclical sector with an improving fundamental outlook We believe the drivers for continued outperformance from the Tech sector are in place: valuations are low, companies are aggressively returning excess capital to shareholders, balance sheets remain rock solid and to top it off, the Tech spending environment is improving, While not our base case, a slowdown in the macro economy would reduce some of the upside that we see, but downside should be mitigated by the sector's attractive total yield. In short, we find the risk reward for the Tech sector to be quite attractive.

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Investment Thesis Summary UBS WM R Inf ormat ion Technology: Technology Hardw are - Sect or Out perf orm List Company Ticker Invest ment Thesis Summary Apple Inc. AAPL Apple has three drivers of growth - PCs, the iPhone and the iPad. Competitors would kill for one! The company's market share is quite low in all segments so there's plenty of room for growth and valuation is modest at best. Cisco Systems Inc. CSCO The company has restructured a number of operations as well as reset expectations for growth. CSCO believes it can grow revenue 5%-7% annually with non-GAAP EPS growth of 7%-9%. This will be coupled with a solid dividend as well as share repurchases. As CSCO delivers on its plans, we believe its valuation will expand from its depressed levels. QUALCOM M Inc QCOM QCOM has seen it s chip business st ruggle due t o lack of capacit y and pricing pressure. We believe t he capacit y issues are behind it and expect chip margins t o appreciat e. Furt hermore, w e believe t hat est imat es f or royalt y grow t h are quit e conservat ive f or FY13. Sandisk SNDK SNDK is very well positioned within the limited number of major suppliers of NAND flash. While NAND does have some commoditylike aspects to it in low-end applications, embedded flash applications are design wins that are not easily replaced by alternative suppliers. We believe mobility and the migration of enterprise storage to solid-state alternatives will drive demand for sometime to come.

UBS WM R Inf ormat ion Technology: Technology Hardw are - Sect or Underperf orm List Company Ticker Invest ment Thesis Summary Fusion-io, Inc. FIO FIO was early to the market for NAND flash memory storage sub-systems used to boost data center applications requiring very high-peroformance. That has led to high growth and a high valuation. We believe that FIO's first-mover advantage is waning as more than 40 different companies have entered the market, so with equivalent performance capabilities and others with cost advantages. We think FIO will see significant price/margin pressure in the coming years putting pressure on the stock. UBS WM R Inf ormat ion Technology: Technology Hardw are - Sect or M arket perf orm List Company Ticker Invest ment Thesis Summary Hewlett-Packard Co. HPQ We believe HP's shares will be challenged for the near-term as the current restructuring of operations fights a number of difficult headwinds. The company has made some headway but it remains very slow going and likely will be for sometime. Intl Business Machines IBM IBM has struggled with top-line growth for some time and a period of weak GDP growth is only going to exacerbate the problem. EPS growth derives largely from streaming acquisitions and asset sales. Subdued booking trends in consulting along with peaking margins keep us from being more positive on the name. Lexmark LXK LXK has been losing market share to much bigger competitors in what is a low-growth, commoditized market. Expect little-to-no EPS growth going forward.

Blackberry

BBRY

The market for smartphones changed with the introduction of the iPhone and Android phones. Blackberry's management did not understand the change that took place and were slow to respond with what are little more than "me too" devices. We believe the window for recovery at Blackberry has closed and it will simply see its market share and fundamentals errode over time.

Source: UBS WMR, 24 February 2014 Note: Companies in BOLD represent High Conviction Calls. Please see the Appendix for definition.

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Appendix Analyst certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his 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 research report.

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

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Appendix Global Disclaimer Required Disclosures For a complete set of required disclosures relating to the companies that are the subject of this report, please mail a request to UBS CIO Wealth Management Research Business Management, 1285 Avenue of the Americas, 13th Floor, Avenue of the Americas, New York, NY 10019. CIO Wealth Management Research Stock recommendation system Analysts provide a relative rating, which is based on the stock’s total return potential against the total estimated return of the appropriate sector benchmark over the next 12 months. Industry sector relative stock view system Outperform (OUT) Expected to outperform the sector benchmark over the next 12 months. Marketperform (MKT) Expected to perform in line with the sector benchmark over the next 12 months. Underperform (UND) Expected to underperform the sector benchmark over the next 12 months. Under review Upon special events that require further analysis, the stock rating may be flagged as “Under review” by the analyst. Suspended An outperform or underperform rating may be suspended when the stock's performance materially diverges from the performance of its respective benchmark. Restricted Issuing of research on a company by WMR can be restricted due to legal, regulatory, contractual or best business practice obligations which are normally caused by UBS Investment Bank’s involvement in an investment banking transaction in regard to the concerned company. Sector bellwethers, or stocks that are of high importance or relevance to the sector, that are not placed on either the outperform or underperform list (i.e., are not expected to either outperform or underperform the sector benchmark) will be classified as marketperform. Stocks that are rated Marketperform that are not sector bellwethers are not assigned a price target. High Conviction Calls Sector analysts are required to have at least one "high conviction" outperform or underperform call for each sector they cover. Analysts have discretion over the selection of a recommendation as high conviction and the grounds for selection (e.g., greatest upside/downside to price target, most/least compelling investment case, etc.). The basis for each high conviction call is set forth in any research report identifying a recommendation as such. Disclosures (27 February 2014) Akamai Technologies 5, 7, 8, 9, 10, Applied Materials Inc. 7, 8, 9, Equinix 3, 5, 9, 10, 13, 14, Google Inc 3, 4, 5, 6, 7, 8, 9, 10, 13, 14, 15; Intel Corp. 3, 4, 5, 7, 8, 9, 10, 11, 12, 13, InterXion Holding 9, Microsoft Corp. 2, 3, 4, 5, 7, 8, 9, 10, 13, Rackspace Hosting Inc. 1, 9, Veeco Instruments Inc. 9, 1. UBS AG, its affiliates or subsidiaries beneficially owned 1% or more of a class of this company's common equity securities as of last month's end (or the prior month's end if this report is dated less than 10 days after the most recent month's end). 2. An employee of UBS AG is an officer, director, or advisory board member of this company. 3. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and investment banking services are being, or have been, provided. 4. This company/entity 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. 5. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-securities services are being, or have been, provided. 6. UBS AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services from this company/entity within the next three months. 7. This company/entity is, or within the past 12 months has been, a client of UBS Financial Services Inc, and non-investment banking securities-related services are being, or have been, provided. 8. Within the past 12 months, UBS Financial Services Inc has received compensation for products and services other than investment banking services from this company. 9. UBS Securities LLC makes a market in the securities and/or ADRs of this company. 10. Within the past 12 months, UBS Securities LLC has received compensation for products and services other than investment banking services from this company/entity. 11. The equity analyst covering this company, a member of his or her team, or one of their household members has a long common stock position in this company. UBS CIO WM Research 27 February 2014

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Appendix 12. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in Intel Corp. 13. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking services from this company/entity. 14. UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of this company/entity or one of its affiliates within the past 12 months. 15. UBS AG, its affiliates or subsidiaries held other significant financial interests in this company/entity as of last month's end (or the prior month's end if this report is dated less than 10 working days after the most recent month's end). Terms and Abbreviations Term / Abbreviation

Description / Definition

Term / Abbreviation

Description / Definition

1Q, 2Q, etc. or 1Q11, 2Q11, etc. Capex E p.a. Shares o/s

First quarter, second quarter, etc. or first quarter 2011, second quarter 2011, etc. Capital expenditures expected i.e. 2011E Per annum (per year) Shares outstanding

A

actual i.e. 2010A

COM NAV P/E Relative UP

WMR

UBS Wealth Management Research

CIO

Common shares Net asset value P/E relative to the market Underperform: The stock is expected to underperform the sector benchmark UBS WM Chief Investment Office

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Appendix Disclaimer In certain countries UBS AG is referred to as UBS SA. This publication is for our clients’ information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situation and needs of any specific recipient. We recommend that recipients take financial and/or tax advice as to the implications of investing in any of the products mentioned herein. We do not provide tax advice. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Other than disclosures relating to UBS AG, its subsidiaries and affiliates, all information expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness. All information and opinions are current only as of the date of this report, and are subject to change without notice. This publication is not intended to be a complete statement or summary of the securities, markets or developments referred to in the report. Opinions may differ or be contrary to those expressed by other business areas or groups of UBS AG, its subsidiaries and affiliates. Chief Investment Office Wealth Management Research Americas (CIO WMRA) is written by Wealth Management & Swiss Bank and Wealth Management Americas. UBS Investment Research is written by UBS Investment Bank. The research process of Except for economic forecasts, CIO WMRA is independent of UBS Investment Research. As a consequence research methodologies applied and assumptions made by CIO WMRA and UBS Investment Research may differ, for example, in terms of investment horizon, model assumptions, and valuation methods. Therefore investment recommendations independently provided by the two UBS research organizations can be different. The analyst(s) responsible for the preparation of this report may interact with trading desk personnel, sales personnel and other constituencies for the purpose of gathering, synthesizing and interpreting market information. The compensation of the analyst(s) who prepared this report is determined exclusively by research management and senior management (not including investment banking). Analyst compensation is not based on investment banking revenues, however, compensation may relate to the revenues of UBS as a whole, of which investment banking, sales and trading are a part. UBS AG, its affiliates, subsidiaries and employees may trade as principal and buy and sell securities identified herein. At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS AG, its affiliates, subsidiaries and employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, groups or affiliates of UBS. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in foreign currency exchange rates may have an adverse effect on the price, value or income of an investment. Past performance of an investment is not a guide to its future performance. Additional information will be made available upon request. This report is for distribution only under such circumstances as may be permitted by applicable law. The securities described herein may not be eligible for sale in all jurisdictions or to all categories of investors. Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. Version as per January 2014. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. © UBS 2014. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

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