Aflac Inc. is a provider of supplemental insurance in the U.S. and Japan. In the U.S., accidental death/disability insurance and cancer insurance are responsible to 65% of the U.S. segment revenue. In Japan, cancer and other health insurance are responsible for 69% of the Japan segment revenue.
The market seems to be grossly undervaluing Aflac. The first place to look is the financial statement. Earnings and free cash appear strong. The company has very little debt. I was puzzled.
We see in 2011 that AFLAC experienced a drop in return on equity. Dupont analysis was applied to see why. Asset turnover seems to be on the decline, but nothing jumped out that says I shouldn’t invest in Aflac. Five factor analyses uncover that Aflac pays almost no interest on debt.
Insurance companies collect premiums from customers and then invest those premiums in bonds. Perhaps the market is undervaluing the company because of the quality of its investments. The market could also be undervaluing Aflac because the bond market is currently inflated.
Here are some charts that expose Aflac’s investment exposure:
Aflac has a significant portion of it’s portfolio in financial institution securities. 35% of it’s financial institution exposure is in European banks, other than the UK. It works out that approximately 10% of the companies assets are in European banks. If we assume all these assets come off the books completely, only 1% to 2% of revenue should be affected. The European debt crisis does not seem to be the reason the market is under-valuing Aflac.
Aflac management is keenly aware of its exposure to European debt and is working to reduce this exposure.
At this point I had to go back to the basics. The majority of Aflac’s revenue is generated in Japan. That means they’re collecting revenue in yen, not dollars.
Let’s convert 10-year earnings to yen, instead of dollars.
EBITDA growth doesn’t seem nearly as impressive in yen, as earnings in dollars. The bump in earnings in dollars is due to dollar value destruction over the past decade.
Since earnings in yen are lumpier than earnings in dollars, applying the standard Ben Graham multiplier of 8.5 times EPS for a no-growth company, you get $36 per share for Aflac, based on 2011 earnings. Add in a 2.5% dividend yield, and you get a price of $46 per share. The current share price is $43.
Aflac devotes a great deal of money to currency exchange programs. The majority of its derivative portfolio is in foreign exchange currency swaps. Aflac also tries to minimize currency fluctuations on the value of net assets. They accomplish this by investing a portion of Aflac Japan's investment portfolio in dollar-denominated securities and by the parent company's issuance of yen-denominated debt (as a result, the effect of currency fluctuations on net assets is reduced).
Other business risks to Aflac include:
• The Dodd-Frank law, which gives regulators more authority to place significantly more regulations on insurance companies that could have be a grave threat to the financial stability of the U.S. Aflac doesn’t think it will fall under this provision of the Dodd-Frank law.
• De-regulation of insurance in Japan. Insurance companies that would otherwise have competed with Aflac in Japan will be allowed to enter the supplemental insurance market.
Near-term growth prospects in the U.S. are expected to be relatively flat due to the economy. Aflac feels that in the long term, its insurance products will have solid demand.
Conclusion: Aflac is a stable company in good financial health. There is some risk due to European debt exposure, but the exposure seems to be immaterial to cash flows. EPS growth is primarily dependent on the yen/dollar exchange rate. In the near term, it seems the likelihood of the dollar rising in value relative to the yen is low, given historically low yields on 10-year Treasuries. Aflac is a solid investment in an uncertain market selling at a slight discount to fair value. Investors should have an eye on exchange rates as a stronger dollar (weaker yen) will destroy value.
Disclosure: I am currently long Aflac.