Monday, November 30, 2009

Aflac (NYSE:AFL): Upgraded to Outperform at Credit Suisse; target raised to $60

Credit Suisse is out with an interestingly timed upgrade on Aflac (NYSE:AFL) raising their rating to Outperform from Neutral with a $60 price target (prev. $52).

Action: After sizing up potential losses and recent actions to restructure European banks’ capital positions, the firm upgrades Aflac to Outperform and raise their target price to $60. According to the firm their upgrade also considers the following: 1) Improved recent fundamental trends, including an up-tick in persistency and a wider gap between incurred claims and benefits paid, 2) reserve redundancy averaging over 20% (~$500m) per year, for which they believe may fully offset AFL’s prospective credit losses and (3) a potential RBC arbitrage (from selling or “derisking”) as a result of a continued rally in bank hybrid security prices relative to NAIC capital charges and 4) a manageable EPS impact if the company did in fact liquidate a large portion of its hybrid portfolio (less than a 5% EPS reduction).

Investment Case: With the assistance of CSFB's global credit research peers, the firm has composed a scenario analysis in regards to what they perceive to be AFL’s most at risk investments; totaling $12.7 billion dollars and representing the majority of AFL’s unrealized losses. Specifically, the analysis includes over 50 issuers, broken down into pools by risk assessment. Credit Suisse hase determined that AFL owns $1.8bn of securities that are at risk of coupon deferral, $2.3bn at heightened risk of some type of principal loss, $6.9bn they deem to be money good and $1.1bn which are more obscure instruments that are harder to analyze but they believe real losses will be well within current unrealized marks. In firm's base case analysis, they have concluded that AFL will be able to maintain an RBC ratio well in excess of 400% in the coming year, attributable to its industry leading cash flow generation (25% ROE) offset by manageable ratings migration and credit losses. Additionally, they note that AFL’s 20% debt to capital ratio could be further levered ($500 million / proforma 24% debt to cap / 2% EPS dilutive) in order to maintain a healthy capital cushion.

CSFB's analysis also considers 1) headwinds stemming from Moody’s wholesale ratings downgrades for which AFL has $8bn of securities exposure to, 2) the impact of potential interest rate “step-downs” on the perpetual portfolio in the coming years and 3) AFL’s susceptibility to a sustained lower interest rate environment.

Valuation: AFL currently trades at 8.3x CSFB's 2010 EPS estimate versus its peers at 7.1x. AFL has historically traded at 15-20x one-year forward earnings and generated year/year EPS growth of 15% (currency adjusted). They believe AFL can achieve its intermediate low-double-digit EPS growth target versus their low-to- mid single digit growth forecasts for its peers. AFL also has the least capitalintensive business among its peers. Firm bases their new $60 target price on 11x their 2010 EPS estimate of $5.25, to reflect their forecast of ROE's just north of 25% and steady earnings growth.

Conference Call: Credit Suisse will hold a call on Monday, Nov. 30th, at 11am ET to discuss their report in more detail. European credit research team will provide a brief overview on their assessment of the European debt market and will also be available during Q&A.

Notablecalls: I was surprised to see CSFB upgrade Aflac this morning following the fall-out in Dubai last week. Aflac has exposure to various hybrid securities (debt/equity) and the Dubai news sent some shivers around that space. There is no way to tell if the Dubai thing will remain a local problem or can be considered a precursor of things to come in larger scale.

Yet, here's the upgrade and I think people that were shorting Aflac on Friday based on Dubai news will get squeezed big time.

To add fuel to the fire, CSFB is holding a conf call to discuss the lengthy upgrade. I suspect that will ensure continuous buy interest in the name today.

So, all in all I think AFL will have a fair shot of trading towards the $45 level and possibly higher if the market continues to play ball. New highs are not that far off.

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