As one of the first companies licensed by the Japanese government to offer supplemental insurance, and the first to offer cancer policies in Japan, Aflac Inc. (AFL) was able to grow substantially over the past few years, with soaring revenue and earnings per share increases (jumped from $4.12 in 2012 to a current $6.76). However, while the firm is currently underwriting 80% of all cancer policies in Japan, this landscape begun to shift of late, and deregulation on Japan’s financial system has deepened competition, with several Japanese insurers now issuing supplemental policies. Furthermore, the company’s latest price increases on its hybrid life product, WAYS, has caused new sales in Japan to drop by 33% year over year for fourth quarter fiscal 2013, but margins improved considerably due to strong underwriting.
A Unique Business Model
One of Aflac’s most interesting features is its geographic focus. While rooted in the U.S., Japan is its primary market, generating about 75% of annual premium revenue via its independent distributors, who sell supplemental policies (cancer policies) to consumers at their work place. In fact, this system has shown to have several advantages so far. For one, marketing products to companies is clever, since these will tend towards improving their benefits for employees at no additional cost, allowing Aflac to price its policies at a much lower price than competitors. Furthermore, as the company focuses its underwriting on supplemental policies for specific diseases, contrary to other insurers, this enables the firm to price its policies at a lower price, while still producing very high underwriting margins.
However, Aflac remains subject to certain industry risks, given the nature and geographic disposal of its business model. For one, the company’s target group in the U.S., small business clients, is more exposed to the effects of an economic crisis, as was seen during Q4 of 2013, when sales declines by 10% due to slow job growth and uncertainty regarding the U.S. health care reform. Also, the firm’s investment portfolio is exposed to yen-dominated hybrid securities of European banks, which were strongly affected by Europe’s financial crisis. Nevertheless, I believe Aflac’s strong-suit lies in its distribution model and product offering, since it’s unlikely that consumers will shop around for other insurers, as supplemental insurance is deducted directly from their paychecks. Also, as Japan Post’s medical coverage was becoming more and more popular, Aflac was clever in entering in a distribution agreement, from which it will benefit in the long term.
Short-Term Declines but Long-Term Growth
For investors looking to gain a quick profit, Aflac may not be the right choice, as the company’s balance sheet is adjusting to changes in Japan’s regulatory landscape, as well as the U.S.’s economic growth. As such, after two years of extreme growth, the firm’s WAYS product sales are expected to decline by 25%, due to price increases and changes in the standard reserving rate. However, in the long term, growth in Japan should average a 1% annual rate, while the U.S grows at 1.5%, bringing CAGR for the next five years to 2%, down from 2013’s 5.3% revenue growth.
Nonetheless, Aflac’s most appealing aspects, its return on equity of 21.6% and net margin of 13.19% will remain around the same levels looking forward, with the five year projection averaging 20% and 12.5% respectively. Furthermore, the company’s 2.3% dividend yield has been consistent over the past few years and should continue this path in the long term. Considering the company’s stock is trading at a 35% price discount relative to the industry average of 14.0x, I think investors considering a buy shouldn’t wait much longer.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.