Dividend Aristocrats Part 18 Of 52: AFLAC Incorporated (AFL)

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Dividend Aristocrats Part 18 Of 52: AFLAC Incorporated (AFL) by Ben Reynolds, Sure Dividend

Aflac (AFL) is the global leader in cancer insurance.  The company sells supplemental life, health, and accident insurance.

Aflac generates about 75% of its premium revenue in Japan.  The remaining 25% of premium revenue comes from the United States.

Up to this point many of my Dividend Aristocrat reports have ended disappointingly.  Most of the 17 Dividend Aristocrats analyzed up to this point have been ‘holds’, not ‘buys’.

This analysis is different.  Aflac is a buy at current prices.  I am currently long Aflac.  This article will answer the following questions about Aflac:

  • Is the insurance industry stable enough for long-term investors?
  • How will Japan’s struggling economy affect Aflac?
  • Does Aflac have favorable growth prospects?
  • Does Aflac have a shareholder friendly management?
  • What are Aflac’s expected total returns?
  • How does Aflac perform during recessions?
  • Is Aflac stock currently undervalued?

Is the insurance industry stable enough for long-term investors?

The insurance industry is responsible for several phenomenal fortunes.

Warren Buffett’s Berkshire Hathaway is the largest insurer in the world.  The lesser known Shelby Davis made $900 million investing in insurance companies (including Aflac).  Even hedge fund manager David Einhorn has entered the insurance industry with Greenlight Capital Re.

The insurance industry has two primary characteristics that make it suitable for compounding wealth.

  1. The insurance industry is extremely stable
  2. The insurance industry gives investors a negative cost of capital

Insurance has not changed too much since Lloyd’s of London began selling marine insurance in the 17th century.  Insurance uses the ‘law of large numbers’ to spread the risk of a negative event (like a car wreck, house fire, or cancer) over a large pool of people.  If you pay a little each month, you will be covered in the case of a disaster.

The core concept of insurance has not changed much in the last 400 years, and it won’t change in the future.  Technology and ‘big data’ only make calculating insurance risks easier.  The nature of insurance makes it one of the most stable industries in the world.

The stability of the insurance industry is fairly obvious.  The negative cost of capital aspect of insurance is less obvious.  Here’s how it works:

  1. The best insurers (like Aflac) make a profit on their insurance policies. They collect more in premium revenue than they pay in administration and benefits.
  2. Premium money that has yet to be paid out for claims is invested. This is called float
  3. When you can acquire funds to invest for free or get paid to acquire those funds (like the better insurers do), you are effectively being given a negative interest rate loan that you can use to invest. In other words, you get a negative cost of capital.

You can see how negative interest rate loans – called insurance float – can be extremely powerful in the hands of a world class investor like Warren Buffett.  Investing insurance float is how Buffett went from being a multi-millionaire to a multi-billionaire.

How will Japan’s struggling economy affect Aflac?

Aflac is much more a Japanese company than it is an American company.  Aflac generates 75% of its premium revenue in Japan.  This fact has scared many investors away from Aflac because of Japan’s struggling economy.

Here are a few startling facts about Japan:

  • Japan is the most indebted ‘western’ country. Japan has a public debt to GDP ratio of 227%. Compare this to Greece’s debt to GDP ratio of ‘just’ 175%.
  • Japan has an expected negative population growth rate. The Japanese population is expected to decline from 127 million today to 97 million by 2050.
  • The Japanese stock market was worth more in the 1980’s than today, as the image below shows:

I would not bet on the Japanese economy as a whole going forward.  The brutal combination of massive debt and negative population growth means that the youth of Japan today will have a tremendous debt burden.

If interest rates rise, Japan will have to spend a substantial portion of its tax revenues on paying interest on its debt.

It’s critical to note that an investment in Aflac is not an investment in the greater Japanese economy.

Aflac’s annual premiums in Japan grew at an annualized rate of 5% a year from 2005 through 2014. Japan’s population declined by 0.1% a year over the same time period, while the country’s economy (as measured by GDP) grew at just 0.1% a year.

Based on the above numbers, Aflac grew its annual premiums about 5 percentage points faster than the overall Japanese economy.  The company’s growth does not appear to be tied to Japan’s economy.

Aflac is heavily exposed to Japanese government bonds.  Over 38% of the company’s debt securities are Japanese government bonds. If Japan were to experience significant inflation from its loose monetary policy, Aflac could see investment losses.

This doesn’t detract from the company’s insurance business model, but it does call into question the company’s large investments in Japanese government bonds instead of taking a more diversified approach.

Does Aflac have favorable growth prospects?

Aflac grew earnings-per-share at 10.3% a year over the last decade. This double-digit growth period includes both the Great Recession and a period of rapidly falling interest rates.  It was a difficult time for insurers, but Aflac managed to generate strong earnings-per-share growth for shareholders.

Low interest rates cause insurers to generate less profit from their insurance float. The higher interest rates are, the more profits can be squeezed out of the float.

Aflac expects continued growth ahead. The company’s CEO had this to say about expected results for the rest of 2015:

“Having completed the first nine months of the year, I am pleased with the company’s results. We believe those results, combined with our outlook for the remainder of 2015, well-position Aflac for another year of solid financial performance. I want to reiterate our expectation that the growth of operating earnings per diluted share will be in the range of 4% to 7% on a currency neutral basis.

While operating earnings per share growth of 4% to 7% is not terrible, it is below what Aflac shareholders are accustomed to.  The company’s growth has picked up recently.  Constant-currency operating income per share increased 11.9% in Aflac’s most recent quarter.

Aflac has achieved rapid growth over the last decade by finding innovative new sales channels in Japan.  An example is the company’s partnership with the Japanese post office to sell insurance policies.

Going forward, Alfac will continue to grow its operating earnings.  The company should see operating earnings-per-share growth of 5% to 10% a year over the next several years (on a constant currency basis) from organic growth and share repurchases.

If interest rates rise, the company will see earnings-per-share increase as it will be able to invest its float in higher yielding securities.

Does Aflac have a shareholder friendly management?

Aflac has paid increasing dividends for 33 consecutive years.  The company recently increased its dividend payments another 5.1%.

Aflac is committed to repurchase $1.3 billion worth of its shares in fiscal 2015.  This comes to about 4.7% of shares outstanding at current prices.  In addition to strong share repurchases, Aflac stock also has a dividend yield of 2.5%.  Between share repurchases and dividends, Aflac has a shareholder yield of 7.2%.

Aflac expects to generate earnings-per-share of around $6.00 in 2015. The company plans to pay out about $4.50 per share in dividends and share repurchases in 2015, for a total payout ratio (including dividends and share repurchase) of 75%.

With a long history of rising dividends and extremely large share repurchases (done at attractive share prices), Aflac’s management is very shareholder friendly.

What are Aflac’s expected total returns?

Aflac stock has solid expected total returns going forward.

The company should grow premium revenue (on a constant-currency basis) at between 2% and 5.5% a year over the next several years.  In addition, Aflac has a 2.5% dividend yield.  The company will also very likely continue strong share repurchases of 3% to 4.5% a year.  In total, this comes to a total expected return of 7.5% to 12.5% a year going forward.

The company’s total returns by source are broken down below:

  • Organic growth of 2.0% to 5.5% a year
  • Share repurchases of 3.0% to 4.5% a year
  • Dividend yield of 2.5%

How does Aflac perform during recessions?

AFLAC performed well throughout the Great Recession of 2007 to 2009, although earnings-per-share did dip in 2008.  The company’s premium income rose throughout the recession.

Life insurance and health insurance are difficult to cut back on, even in times of economic uncertainty.  As a result, AFLAC’s operations are not significantly impacted by recessions.

The company’s earnings-per-share each year through the Great Recession of 2007 to 2009 and subsequent recovery are shown below to illustrate this point:

  • 2007 earnings-per-share of $3.27 (new high)
  • 2008 earnings-per-share of $2.62 (recession low)
  • 2009 earnings-per-share of $3.91 (new high)
  • 2010 earnings-per-share of $5.13 (new high)

Is Aflac stock currently undervalued?

Aflac is currently trading for a price-to-earnings ratio of just 10.8 (using GAAP earnings).  The company appears undervalued at current prices.

Prior to the Great Recession, Aflac stock traded at a price-to-earnings multiple of around 0.9x the S&P 500’s price-to-earnings multiple.

The S&P 500 currently has a price-to-earnings multiple of 22.2.  This implies a fair price-to-earnings ratio of around 20 for Aflac – almost double the stock’s current price-to-earnings ratio.

Aflac’s low price-to-earnings ratio gives the company’s management a very easy way to deploy excess cash; repurchase shares for cheap.  Aflac’s management has been doing just that, increasing long-term shareholder value significantly along the way.

Final Thoughts

Aflac has maintained after-tax operating margins of over 10% since 2007.  The company rights highly profitable insurance policies.

The only thing that would make Aflac a more compelling investment is if it invested more of its float into other high quality dividend paying businesses rather into debt securities.  Still, the company is an excellent value right now and has a very shareholder friendly management.

Aflac’s combination of a solid dividend yield, excellent expected total returns, a long dividend history, and a low price-to-earnings ratio make the company a favorite of The 8 Rules of Dividend Investing. Aflac makes a compelling purchase for investors looking for additional exposure to the insurance industry.

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