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Aflac: Bad Press Can Bring Good News

September 15, 2011 | About:
John Neff

I've been reading "John Neff on Investing" and came across a situation he encountered in the 80s with beaten down property and casualty insurance companies. Wall Street predicted that asbestos related problems were going to be a liability of approximately $500 billion. Wall Street overreacted and insurance stock prices moved downward significantly. Sounds familiar... Insurance stocks have been beaten down with many of the recent natural disasters in Japan and in the U.S., which have made for some real bargains.

"Instead of focusing on the fate of the insurance industry if costs reached the predicted magnitude, we wondered about the impact once overreactions melted away.” — Ness

Neff decided to buy Cigna at its lows w/ special consideration to the low P/E and well managed business. After the market realized the predictions were overblown Cigna's shares advanced 54% and property and casualty insurers advanced 45%. The S&P 500 gained 29%

AFLAC: (AFL)

One of my favorite stocks right now is Aflac (AFL). This stock has taken a beating over the last year dropping 32% from its highs w/ concerns of the natural disaster in Japan and questions about investments made in European banks. Their investment portfolio is roughly $90 billion and most of that is outside the debt laden Euro banks. Aflac is now selling off or already have sold off much of their exposure to the troubled European countries for a loss. This has scared investors and has created an overblown sell off very similar to Neff’s situation in the 80s.

Key Ratios

Div: 3.5% (31% payout)

Div 5-year Growth Rate: 17.99%

Debt/Eq: 28.3

Fwd P/E: 5.4

P/FCF: 2.0

Valuation

Aflac is sitting on a 2-year low and sporting a P/E around 9. The five-year P/E stands at 15.6. P/B is at 1.35. Besides the drop in 2009 due to the U.S. subprime meltdown we are seeing some record low valuations.

Total Return Ratio

In honor of Neff I will use his Total Return Ratio (Annual Earnings Growth + Yield ÷ P/E Ratio). Analyst estimates have Aflac’s projected five-year earnings at 12% growth. As with all analyst estimates they are usually over optimistic. I’ll play it conservative and cut Aflac’s growth rate to 6%.

6% + 3.3% = 9.3% total return

9.3 ÷ 9 (P/E) = 1.032

Neff considered a total return ratio of .7 as a worthy investment for further research. Using the forward P/E of we get a TRR of 1.722.

Graham Number

I also applied the Graham Number; SQRT (22.5 * EPS * BVPS)

(22.5 * 3.81 * 25.37) = $46.64

I get $46.64 which has a Margin of Safety of 33.5%

Vitaliy Katsenelson’s Absolute P/E Model

This is a new favorite of mine. Generally, Vitaliy assigns expected earnings growth rates with a certain P/E. A no-growth stock is a P/E of 8 (Jae June and myself use a 7 P/E to be safe). Then you add the yield for the "basic P/E.” He assigns business risk, financial risk and earnings predictability with a premium or discount depending on the company (average is a 1). I’ll probably do the full breakdown in another post, but I won’t go into it here. The valuation is explained in great detail by Jae Jun from oldschoolvalue here.

This is the equation:

Fair Value PE = Basic PE x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]

I assigned a 5% discount to business risk, financial and earnings visibility. I assigned earnings growth yet again with 6% opposed to analyst predictions of 12% growth.

Fair value came out to:

P/E: 12.7 FV: $46.39 MOS: 35.1%

@ 12% growth I get a FV of $59.13

Conclusion

I think John Neff would love this stock. On a value basis, a contrarian basis and fundamental basis I believe Aflac is worth investing in. I’m putting my money where my mouth is and have been investing near the lows. As is usually the case, the market has overreacted and they’re ignoring the prospects of this company. I’ll be waiting patiently with a 3.3% dividend for everyone else to recognize this as well.

Thanks for reading,

Kevin Holloway

Patience, perspective, valuation and conviction to go against the crowd.

About the author:

Kevin Holloway
Value investor and contrarian to the core. I've been investing for close to 5 years and learning every step of the way. Currently I am going for my masters in Financial Management and hope to one day analyze stocks for a living. I've been influenced heavily by Ben Graham, John Neff, The Motley Fool and of course Warren Buffett.

Patience, perspective, valuation and conviction to go against the crowd.

Visit Kevin Holloway's Website


Rating: 4.0/5 (26 votes)

Comments

ranjitsudan
Ranjitsudan - 3 years ago
I am not sure if these formula are appropriate for valuing insurance company. Insurance and banking sector has different set of variables/ratios for valuation like reserves, underwriting discipline and so forth.

I had a quick read through 10-K, Company looks financially strong, however Aflac earning's has major currency exposure to yen. Yen is at all time high so I would factor that into valuation also. I usually buy company at 50% discount to their intrinsic value, stock still needs to go down further to have appropriate margin for safety. Also interesting to see no insider buys at all time low for this stock!!

Overall company looks good to start further due diligence.
AlbertaSunwapta
AlbertaSunwapta - 3 years ago
"however Aflac earning's has major currency exposure to yen"

Now looking forward, is that bad or is it good? Don't forget, most US insurers have major currency exposure to the US dollar. :-)

Personally, I picked up a small position in AFL this summer because of its decent value metrics and because of its very large exposure to the Japanese economy.

Note: I'm ever optimistic about the Japanese market eventually turning around. It's debt is mostly domestically owned which should mitigate much of the effect on the yen, its has great access to rapidly growing markets, its demographics are in run-off, etc. However, if Japanese debt financing goes international in a big way I don't know how that would affect the Yen because of the interaction of Japan's strong competitive position on existing international borrowers.
ranjitsudan
Ranjitsudan - 3 years ago
I personally think yen will be weaker against US dollar but I could be wrong. Strong Yen is not good for export driven japanese economy, I see BOJ intervention if yen remain stronger against US dollar. One way or the other its important to include this in your valuation.

US dollar exposure to any other major currency is good for US insurer but I am not sure about yen. Its trading at all time high.

KJHValue
KJHValue premium member - 3 years ago
I believe the absolute P/E model already takes into account any financial risks. I played it very conservative with the business risk, financial risk and earnings predictability. Assigning a 5% discount to each and cutting the earnings growth forecast to 6% vs. the 12% that analysts are predicting. I'm not saying this stock wont drop further, which I hope it does. I would love to buy more at a lower price.

This discussion is exactly like the situation Neff encountered in my article. The market over exaggerated their concerns (exposure to the Yen, European debt, asbestos damages) instead of looking long term at the earnings potential. I think this is already reflected in the stock price. By the time this is realized it's usually to late.

Eventually Aflac will continue to do business as usual; things will revert to normal and the stock price will reflect that.
AlbertaSunwapta
AlbertaSunwapta - 3 years ago
I'd say Japan isn't really export driven. 16% or something of the GDP. It's just that Toyota, etc. are high profile exporters.
ranjitsudan
Ranjitsudan - 3 years ago
KJHValue: Insurance business is fine. The issue is with investment portfolio, I think they will have to derisk their portfolio further as european debt crisis deepens. We still in early stages of european deb crisis, lots of bad news still to come. Aflac has too much exposure to european banks and financial institutions, I don't think they will leave unscrathed. How much more write downs is anybody guess? Management has been slow in derisking their exposure to greece and ireland, let see how promptly they act (rather than react) to europe crisis.

If more write downs are coming, share price could get cheaper and cheaper!!
mcwillia
Mcwillia - 3 years ago
Aflac's Yen Story...

Aflac's yen situation is far more nuanced than at first meets the eye. It is a double-edged sword for the company and for Japan. A higher yen means better EPS for Aflac but results in a lower RBC captial ratio, restricting policy growth and threatening the dividend and share buyback operations. Many of the portfolio bonds are yen denominated but pay dollar coupons. Others are dollar-bonds altogether. A higher yen also depresses Japanese GDP, which may drive down demand for 3rd sector insurance products. There are dozens of moving parts in this forex gearbox. On the whole, a rising yen is still good for Aflac, but not in the way and to the degree people suppose. But the big risk is a falling yen, which if pronounced enough, could greatly harm Aflac. Will this happen? Let's look.

The yen may fall if capital flows reverse or if Japan reflates aggressively. The biggest and easiest reason this will not happen, is that it is NOT happening. If Japan could reflate and repel capital flows, they would. Japanese businesses are placing huge pressure on the government to do just this, but it is not happening. So empirically, it is clear that for some reason they can't. Now that being too simple, let's look a bit deeper...into why they can't.

Japan will resist reflating, or fail at it, for several reasons. First, in order to reflate, one must essentially print money. But this alone does not do the job. You must out-print the other money printing countries, otherwise your relative rate will not decrease. Japan must out-print the two largest trading entities on earth, The U.S. and the Euro-zone, in order to get any reductive effect. Out printing net-debtor nations is politically disastrous and economically damaging when you are a significant net-creditor nation. Even worse, Japan's biggest trading partner, China, is pegged to the dollar and moves along with Washington's printing press. Japan has little hope of out-printing these three giants. Japanese efforts to reflate will therefore produce domestic inflation, but no relative currency weakness. This will act only to cripple the profitability of its already shaky banking system and thus act to further contract credit.

Second, the resulting liquidity has to be put into a place in the economy where it will stimulate demand. Japan injected very high levels of liquidity in quantitative easing during the 2002-2006 era, but the banking system largely absorbed it all, either placing it abroad in foreign bonds to take advantage of the higher foreign rates (the carry trade) or using it to patch up bad loans, pay down debt, and enhance capital. Little was lent, and no multiplier effect ensued. It belatedly drove up the yen a bit, but only because the U.S. and Euro-Zone were not in the printing mood during that time.

Third, if the Bank of Japan adopts highly inflationary rhetoric, it will drive up interest rates at the long end of the curve, which will again impair lending, particularly in real estate, which will drag down GDP and drop prices even more. This would exacerbate the Banks' problems with undercollateralized loans.

Fourth, Creditors gain from deflation. Japan is a net creditor country with shaky banks, who are in defacto control of the Keidanren, the Bank of Japan and the Financial Services Agency. Deflation is a net gain for the banks and inflation is bad for them. What is ultimately bad for the banks is simply not going to become policy, no matter how bad the manufacturers want it. Within the Keiretsu groups, the banks seem to be calling the shots.

Fifth, Japan retains a healthy zenophobia, and a weaker yen invites foreign acquisition of national assets at fire-sale prices, something the Japanese are not wild about. This is not a primary factor but plays a tertiary role, at least in providing some comfort levels for policy decisions based on the more primary factors. I want to soft peddle this, but it is part of the dynamic.

So there is not a great danger of massive fall of the yen due to reflation. Japan can't reflate to drastically enough to have a real effect without killing its banking sector and unleashing horrible inflation.

That leaves capital flows. These is predominantly risk capital seeking safe haven currencies and Japan's own companies' overseas holdings flowing back when propitious. Trade and current account surpluses are always pushing the yen steadily upward, but they are not the big movers, rather the capital account is what matters. Reflation will send up interest rates, which will invite MORE of the risk-off save-haven capital into the yen and bring an avalanche of capital back home which is presently held by Japanese companies in their overseas investments. Therefore, the reflationary attempt will produce, paradoxically, high inflation and a HIGHER yen rate, and a lower GDP. Sucks to be them, huh.

Soooo, go ahead and invest in Aflac, the yen wont fall much, and will likely rise over time.

ranjitsudan
Ranjitsudan - 3 years ago
Thanks for the insight on yen currency movement. On other note: could you please how strong yen will suppress RBC ratio as asset and liabilities are both in yen for Aflac Japan?
mcwillia
Mcwillia - 3 years ago
Aflac's Capital See-Saw

A significant amount of Aflac's statutory capital and surplus is effectively hedged by dollar-denominated assets. Therefore, while improving U.S. reported earnings-per-share, a stronger Yen reduces Aflac's ratio of total adjusted capital to required capital, i.e. the yen-required asset base stays the same against a shrinking batch of dollar-denominated bonds. A spike in Japanese interest rates would likewise pressure the solvency ratio for the same reason. The key is to determine how much portfolio 'pain' Aflac can withstand before regulators force it to raise equity, and actually it is quite a lot, certainly more than the market is presently presuming. Here are the reasons.

Each quarter, Aflac earns another 600 million which can, if needed, be put in the Japanese subsidiary to shore up regulatory capital. But, there is another hidden safety valve: the fact that spiking yen and interest rates will harm Aflac's competitors far worse than Aflac, as these companies have significantly higher rate-sensitivity problems than Aflac and much more vulnerable portfolios, many of which are chock full of underperforming Japanese equities and (ugh!) real estate. As Aflac approached the danger zone, its competitors would be crossing the line of death, so to speak, which would trigger an easing of capital requirement calculation formulas by the Financial Services Agency. When one considers that Aflac's Japanese competitors have potentially much worse exposure to European debt, the relative attractiveness of Aflac's position becomes even clearer. This is an under-appreciated shock absorber working in favor of Aflac's solvency.

The FSA is not about to stand by and see the Japanese insurance sector destroyed, especially in the wake of the Tsunami, as the Ministry of Finance is relying on the insurers to shoulder more and more of the reconstruction costs and National Health Ins. burdens as these progressively bust the budget. The Japan Post Office will lobby hard against pushing Aflac policies off its shelf and the loss of face it would entail. Most of Japan's banks will likewise pressure the FSA to take it easy on the Duck, since Aflac's policies pay higher commissions to the bank-salespersons AND offer lower premiums to their customers than the competition (it pays to be the low cost provider, and how.)

In essence, Aflac's solvency margins are in far better shape than commonly supposed. A gut check is the fact that the dividend was not even cut, nor was there any share dilution, during the 2008-2009 financial crisis. A pleasant afterthought is the fact that since the tsunami, Aflac has earned another $1.3 billion, has increased its float and widened its underwriting profitability.

Lastly, consider that Aflac earns over $200 million per month...This is equivalent to its entire exposure to Bank of Ireland debt every 3 weeks, its entire Banco Santander or BNP Paribas exposure every 2 months. Since the spring tsunami and Euro crises, Aflac has already earned the equivalent of its Entire current exposure to Ireland, Portugal and Italy combined...BUT Aflac has 16 Billion of Japan Government Bonds. Tiny shifts in relative interest rates, exchange rates, and capital flows between Japan and the world have huge consequences for this part of the portfolio, although it seems that nobody pays much attention to it, everyone being focused on Europe.

Understanding Aflac, therefore, means ignoring Europe and focusing instead on Japanese interest rates, inflation, exchange rates, fiscal posture, asset prices and financial sector regulations. In these critical areas, Aflac is bashing its competitors to bits and is set to continue to do so for some years to come.

ranjitsudan
Ranjitsudan - 3 years ago
Thanks for your insight once again! I respect your judgement on AFLAC. My initially thought about AFLAC was that it's a cheap stock. However, after digging more into 10-K, it is not as cheap as I thought both from earning and balance sheet prespective.

If you look at earnings, insurance business is barely profitable in last 5 year, avg comprehensive ratio for last 5 year around 100. Most of the earning is coming from investment income. Given their europe exposure, their will be write downs in future, which will effect investment income as well. Major portion of increase in premium earned is inflated by strong yen, otherwise AFLAC japan earned premium is growing at mere 3%.

Looking at the balance sheet, tangible book value is close to $10 after adjusting deferred acquistion costs (DAC), which are intangible asset. I am not sure of your solvency ratio has accounted for DAC! At current price of $35, you are paying 3.5x its tangible book value for the assets which are badly allocated to european govt debt and banking institutions, earning which are inflated by strong yen and invst income otherwise hardly growing.

Its a tough call to buy AFLAC at these prices. Strong yen story seems all well, but fundamentally AFLAC is still trading at high price both from earning and book value prespective. Compare this with Berkshire which is currently trading at about book value, seems to be better value.

ranjitsudan
Ranjitsudan - 3 years ago
Correction on tangible book value - its $4.16 per share. I used DAC for Alfac Japan only in my calc. So calc is as follows:

As of 30 June 2011

Total Asset: 106,232

Less DAC: 10,028

Less liabilties: 94,251[/b][b]Net Asset: 1,953

Share OS: 470 M approx

Net Tangible Book Value: $4.16

Current Share price: $35

Price-to-tangible book: 8.42

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