CHSI Catalyst Health Solutions, (MM)

Recently, we reiterated our recommendation on Aflac Inc. (AFL) at Neutral, based on the current sustainability factor. The company’s third quarter operating earnings per share of $1.66 came in comfortably higher than the Zacks Consensus Estimate of $1.60 and $1.45 reported in the year-ago quarter. Operating earnings also escalated 13.7% year over year to $778 million.

Growth in the third quarter was supported by higher premium income, modest investment yields, favourable dollar/yen exchange rate and improvement in the U.S. operations. However, higher claims and benefits and higher investment losses due to de-risking activities partially dampened the positives.

Aflac has been achieving its earnings target for the past 22 years, which is reflected in its consistent dividend increment. The company’s strong brand name and solid business model enabled it to improve earnings considerably faster than other life and health insurers such as Unum Group (UNM) and Catalyst Health Solutions Inc. (CHSI).

Aflac had been strengthening its Japanese operations regularly, which also helped itself to survive the catastrophe losses better than its peers. Japan’s revenues accounted for 83% of the company’s total revenue in the first nine months of 2011, steadily increasing from 77% in 2010 and 73% in 2009. Factoring all the growth prospects, management now expects the earnings growth of 2–5% for 2012, up from the prior expectation of negative growth over 2011.

Optimistic earnings growth outlook is also reflected in Aflac’s consistent dividend increment and ongoing share repurchase program. Maintaining this trend, in October 2011, Aflac hiked its fourth-quarter dividend by 10% to 33 cents per share from 30 cents. Besides, the company’s investments and cash position is experiencing a steady growth.

Further, Aflac’s National Association of Insurance Commissioners (NAIC) risk-based capital ratio was estimated in the range of 500–540% and in the third quarter of 2011, which also reflects its improved ROE and is impressive given the ongoing de-risking program.

Meanwhile, Aflac also aims to get rid of its problem investments in Europe through its proactive de-risking process, which is expected to last over the next 12 months. We believe Aflac is quite capable of sustaining losses from these investments. Going ahead, the strong capital and surplus cash position are expected to mitigate this balance sheet risk and provide liquidity cushion to its long-term growth.

However, Aflac continues to be hit by intense economic volatility, the continued fluctuation of the yen against the dollar, changes in interest rates, changes in credit spreads and defaults, market liquidity and declines in equity price.

Despite the fact that Aflac is indulging in de-risking activities, it is moving toward investments with less risk and lower yields, which will further lessen investment income. Moreover, the company’s substantial exposure to European financial institutions hybrid securities, below-investment-grade debt and perpetual securities is likely to result in statutory investment losses and lower reinvestment yields, thereby escalating the financial and capital risk.

Besides, increasing expenses from operations, benefits and claims continue to weigh on the margins. Losses from investment portfolio are also expected to continue to hurt the earnings at least in the near term, until the markets witness steady recovery. This is also reflected in management’s estimation of earnings of 8% from prior 8–12% in 2011.

Based on the above factors, the Zacks Consensus Estimate of earnings is currently pegged at $1.51 per share, up 14% year over year, for the fourth quarter of 2011. This is also within management’s guidance of $1.45–$1.52 per share. Three of the fifteen firms covering the stock have revised their estimates upward for the upcoming quarter, while a couple of downward revisions were witnessed. For 2011, earnings are estimated to be $6.37 per share, up about 15% year over year.

Additionally, the quantitative Zacks Rank for Aflac is currently #2, implying a short-term Buy rating. However, long-term stance remains Neutral.

 
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