Aflac: An Opportunity During This Dip

Aflac (AFL), the insurance company, has appeared on GuruFocus Undervalued Predictable screens lately, most recently on June 23, 2014.

Many of us know the company by its iconic duck, but how many of us know that life insurance is a minority of its business, and that the United States comprises only about a quarter of its market?

Aflac, it turns out, focuses on specialty insurance lines, particularly those connected with health care. And, about three quarters of its revenues are booked in Japan.

As the following GuruFocus chart shows, the stock price has dipped and stalled since the beginning of 2014:

This price action reflects several significant challenges to the company:

• A major shift in the yen/dollar exchange rate. The exchange rate does not affect Aflac operations, since income booked in Japan is invested in Japan, but it does make the financials look less attractive than they really are;
• Low interest rates, which reduce its income from investments;
• In the U.S., uncertainty about implementation of the Affordable Care Act, which has prompted some potential policyholders to delay purchase decisions;
• A one-time sales spurt in the Japanese market in the first half of fiscal 2013 led to unfavorable comparisons for later periods.

Takeaways: Aflac no doubt has been the victim of perceptions, incorrect perceptions likely, but perceptions that affect price nevertheless. These have to be considered part of the price of doing business internationally and in the U.S. health care market; the effects may be positive in some years and negative in others.

The Aflac Business Model

The following comes from AFL’s 10-K report, filed December 31, 2013:

• “Aflac Incorporated is a general business holding company and acts as a management company, overseeing the operations of its subsidiaries by providing management services and making capital available.
• “Its principal business is supplemental health and life insurance, which is marketed and administered through its subsidiary, American Family Life Assurance Company of Columbus (Aflac), which operates in the United States (Aflac U.S.) and as a branch in Japan (Aflac Japan).
• “Voluntary insurance policies provide a layer of financial protection against income and asset loss.
• “Aflac Japan sells voluntary supplemental insurance products, including cancer plans, general medical indemnity plans, medical/sickness riders, care plans, living benefit life plans, ordinary life insurance plans and annuities.
• "Aflac U.S. sells voluntary supplemental insurance products including products designed to protect individuals from depletion of assets (accident, cancer, critical illness/ critical care, hospital intensive care, hospital indemnity, fixed-benefit dental, and vision care plans) and loss-of-income products (life and short-term disability plans).”

Takeaways: A company with a niche, and focused on one international market, as well as the domestic market.

A Brief History of AFL

The following milestones in the company’s development come from the Aflac website:

• 1955 – Brothers John, Paul, and Bill Amos found the American Family Life Insurance Company;
• 1964 – The company changes its name to American Family Life Assurance Company of Columbus, and later adopts the acronym Aflac;
• 1974 – American Family Life Assurance Company of Columbus lists on the New York Stock Exchange (AFL opens at $7.25);
• 2000 – The Aflac Duck’s first commercial, “Park Bench,” airs;
• 2009 – Aflac completed its acquisition of Continental American Insurance Company, which is currently branded Aflac Group;
• 2012 – Aflac appeared on Fortune Magazine’s list of The World’s Most Admired Companies for the 11th time;
• 2013 - increases dividend for 31st consecutive year, and clocks six years on the S & P Dividend Aristocrats list.

Takeaways: A relatively young company with several important acquisitions and accomplishments, including S & P Dividend Aristocrat status.

Ownership

• Gurus: For the period ended March 31, 2014, two gurus initiated new positions, three sold out, three increased their holdings and two reduced. To see the full list of gurus holding (or who held) AFL, see the Guru Ownership page;
• Institutional Investors: Own about 72% of outstanding shares; their percentage has generally fluctuated between 60% and 70% over the past six years;
• Insiders: Own about 1%; in the wake of the 2008 crisis, insiders dropped from about 3% to 1%, and have remained there since;
• Short interests: As the following chart shows, short interests are low, around 1%, and (with exceptions for gyrations in late 2008 and in 2009) have fluctuated between 1% and 2% since 2006:

Takeaways: Ownership holdings by key investor constituencies has remained relatively stable over most of the past decade. Aside from some wild swings brought on by the events of 2008, there have been no significant ups or downs in their holdings.

Aflac by the Numbers

Growth Strategy

At the company’s website, it sums up its growth plan this way,

“Our strategies for growth are very simple:

“1. To continue expanding our product line.
“2. To focus on growing our distribution system of independent insurance agents and insurance brokers.”

Takeaways: As the company says, a simple strategy (although the people implementing it might tell us the devil is in the details), and performance would suggest they’ve carried it out effectively

Financial Strength

GuruFocus gives Aflac a 7/10 rating, as follows:

At the same time, it issues two Severe Warning Signs, for its Altman Z-Score and for Asset Growth (faster than revenue growth).

• Looking first at the Altman Z-Score, we should note it is usually not appropriate for an insurance company, As a Wikipedia article notes, “Neither the Altman models nor other balance sheet-based models are recommended for use with financial companies.”
• The same holds for the Asset Growth warning: the assets of an insurance company will be cash or marketable securities (normally matched against its long-term policy commitments), rather than bricks and mortar. Looking at a portion of the Aflac balance sheet we see that only about 10% of its total assets are non-financial:

• Aflac’s status as a member of the S & P Dividend Aristocrats should help inform our view of the company’s financial strength; AFL has increased its cash dividend every year for 31 years (as of fiscal 2013);
• Share repurchases: AFL has actively bought back its own shares, and for 2014 Chairman and CEO Daniel P. Amos predicted (2013 Annual Review) that the company will buy back $800-million to $1-billion worth of stock.

Takeaways: Overall, it would seem safe to ignore the Severe Warning signals; in addition to being largely irrelevant to a financial firm, we also have an outstanding record of increased dividends and a strong share repurchase program.

Management

• 62 year old Daniel P. Amos, the Chairman and CEO, is one of three second-generation members of the Amos family serving on the Board of Directors;
• Despite deriving some three-quarters of its income from Japan, a review of the director biographies shows just one director with connections to Japanese business or institutions. This may harm its ability to do high level intelligence gathering and analysis.
• Fortune Magazine has included Aflac on its list of the 100 Best Companies to Work For, at least 14 times;
• According to the company’s official history, Aflac was was the first company to offer its shareholders a nonbinding Say on Executive Pay;.
• Despite the leadership on executive pay, Aflac receives a 9 rating on the ISS Governance QuickScore; in this system, 1 means low governance risk, 10 means high governance risk. AFL gets red flags for Board Composition [see my note above on board representation from Japan], Board Practices, Related Party Transactions, Pay for Performance, Use of Equity, and Controversies. Nevertheless, institutional shareholders hold nearly two-thirds of AFL’s outstanding shares (64.5%).

Takeaways: On the positive side, the company’s CEO is young enough to continue providing leadership and continuity for a number of years; inclusion in the 100 Best Companies to Work For list suggests a strong and stable workforce; continued dividend increases and share buybacks indicate a focus on meeting shareholder needs. On the negative side, Aflac has minimal boardroom representation from Japan, its major source of revenue. The ISS Governance QuickScore shows other areas which may concern investors.

Valuation

As the following GuruFocus chart indicates, two important metrics indicate AFL is significantly undervalued:

• As noted in the Financial Strength section, firms in the financial sector gravitate to financial, not tangible assets, so we can ignore the overvalued reading for Tangible Book;
• Projected free cash flow, at $324.12 (compared to its current price near $63), seems high, and I would suggest we treat it as an outlier;
• Median Per Share Value and the Graham Number suggest the company is close to fair value at its current level;
• Turning to the Peter Lynch Value indicator, it clocks in at $141.71, roughly twice the current price. Here’s how the Lynch chart compares the stock price and theoretical earnings of 15x:
• 
• Finally, let’s look at the GuruFocus Price/Book Ratio chart, which indicates AFL is trading near the low end of the P/B range set over the past 15 years:

Takeaways: The only indicator suggesting AFL is overpriced can be ignored; two suggest fair valuation; and two suggest it is underpriced. The P/B chart indicates the price in relation to book value is about as low as it’s going to go.

Outlook

• Operationally, there appear to no serious impediments to Aflac’s growth in Japan or the U.S.A. Demographic pressures from an aging population and limited government resources for health care spending suggest the Japanese will continue to need coverage for deductibles (or co-payments). Aging populations in most developing countries should provide good markets for cancer policies;
• On the American front, uncertainty about the Affordable Care Act should ease over the next few years. In addition, Aflac continues to develop products and sales channels for growth;
• From a marketing perspective, AFL has at least two strong assets: The brand, used in both Japan and the U.S.A., which provides an entry to new, prospective policyholders, and 50-million existing customers;
• Turning to valuations, the Peter Lynch chart (as seen above) suggests that the stock price should rise to at least lessen the gap with the earnings line. Currently, we see both the trailing and forward P/E ratios sitting below 10;
• Our look at the historical price to book ratio (above) suggests the ratio is relatively low, compared to where it’s been over the past decade. For more information on the importance of P/B, see the recent article titled, “This Investment Metric Outperforms All Others”.
• AFL enjoys a four and a half star (out of five) Predictability rating, which is very good. As a GuruFocus Research article notes, “...these [predictable] companies had much better stock performance than the others, and more importantly, the chance of losing money when investing in these is much smaller.”

Takeaways: Overall, AFL offers a positive outlook; I would expect occasional hiccups, like shifts in exchange rates, but the underlying business is strong and should stay that way.

Conclusion

Since the beginning of 2014, the price of Aflac stock has taken a hit, first with a sharp pullback, and then several month of sideways trading. So we have to ask if this represents an opportunity to buy an S & P Dividend Aristocrat at a discount price, or if there’s the threat of more slippage to come.

Based on what we’ve seen in this analysis, it seems more likely that we have an opportunity than a threat.

From both an operational and valuation perspective, AFL appears strong, and the price dip a result of unusual circumstance. Management’s focus and guidance have been effective overall, and I would expect that to continue in the foreseeable future.

Therefore, I would recommend Aflac for further consideration by value investors.