Thursday, August 13, 2009

Assured Guaranty (NYSE:AGO): Upgraded to Overweight at JP Morgan

JP Morgan is upgrading Assured Guaranty (NYSE:AGO) to Overweight from Neutral and establishing a $23 price target.

According to the analyst they are upgrading AGO to OW on the results of our deep dive, security-level MBS loss analysis for the AGO/FSA combined MBS portfolios. Firm concludes AGO will need to add $745M to combined reserves for mortgage losses over the next few quarters. However, given AGO should generate $1.7B of unearned premium discount from the FSA acquisition completed on July 1, created by purchasing the company well below book value, modeled losses are still well covered by projected earnings. Based on JP Morgan's FY09 EPS estimate of $2.35, they are upgrading shares to OW and assigning a YE09 price target of $23, which is 10x earnings vs. a historic 10.5x multiple. Although they believe the stock warrants a premium to historic levels due to its dominant market position, they are hesitant to assign a higher multiple, as the firm is skeptical of long-term growth trends in financial guarantee.

Security-level MBS analysis projects $2.4B of future losses in base case. Firm's analysis assumes another 10% decline in home prices nationally from current levels in the base case, with varying default and severity assumptions across vintages and product types provided by J.P. Morgan ABS research. After adjusting for June 30, 2009 MBS reserves at AGO and FSA, they model $745M of additional reserves are necessary on a present valued basis. They stress case of an additional 14% decline in home values nationally would require $914M of additional reserves.

TruP CDO losses likely, but accumulated unrealized loss from derivatives should cover most of it. We model the Trust Preferred. CDO portfolio losses will total $300M on a present value basis, but assume this impairment is covered by the $958M of credit derivative liability on AGO’s balance sheet in 2Q.

Increasing estimates on acquisition, updated reserve estimates. Firm is increasing their FY09 Op. EPS estimate to $2.35 and introducing their 2010 estimate of $2.87. JP Morgan notes their estimates are well below consensus, which may be due to the fact that their peers have not performed a similar security-level analysis.

Upgrading to OW on valuation. Although the positive earnings impact from the FSA acquisition is straight-forward, they had reservations regarding the additional $15.4B of MBS exposure AGO was taking on through the deal. However, after completing this security-level analysis, the firm feels significantly more comfortable with the magnitude of potential future losses.

Notablecalls: This looks like the strongest call of the morning. I tend to like this one as JP Morgan carries weight and the chart looks like it wants higher.

JPM's estimates are below those of its peers and the expectation of another 10% decline in home prices seems prudent in light of recent bottoming in the housing market.

I suspect a 4-6% move is in the cards today.

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