Shares of Aflac (AFL) were down 4.3% on Wednesday after the company reported Q4 2012 earnings. I believe investors are overreacting to worries about the yen (a weaker USD/JPY exchange rate negatively impacts Aflac's bottom line) and the firm's margins.
I first began recommending the stock, specifically for DGI, or dividend growth investors, back in July. Management has grown the payout 11.3% annually over the past five years, and typically repurchases stock at favorable valuations when the solvency margin ratio, which measures the ability of insurers to pay regularly scheduled claims, is at reasonable levels. Management plans on buying about $500 million worth of shares, or roughly 10 million shares at current prices. It is currently authorized to buy up to 22.4 million shares, or about 5% of outstanding shares.
With management clearly focused on successful and efficient shareholder return, the dividend component of DGI investing is well taken care of. While a 11.3% dividend growth rate is usually unsustainable for any company over a period longer than five or so years, it's plausible that AFL will deliver high single digits dividend growth for quite some time.
As for the underlying business prospects, I was encouraged by the Q4 report, though it clearly spooked some investors. Aflac does about three-quarters of its business in Japan, so I'll start there first.
Premium sales growth slowed considerably in Q4 to 1.5%, but management was quick to note the difficult comparisons they had. The company generated exceptional sales growth via their bank channels in 2011, a distribution tactic that happens to work very well in Japan. Q4 2011 expansion into these lucrative channels made it difficult to display strong comparable growth. If we look at full year sales growth however, it was up nearly 31% compared to fiscal 2011. Actual revenues rose 9.4% yearly.
Aflac's WAYS product has been hugely successful Japan, and although management is concerned with new, similar offerings from competitors, they believe that Aflac's strong brand name will aid in the retention of customers even if premiums rise. WAYS generates a premium that is ten times higher than its average health insurance product.
Japanese premium sales are expected to be flat to up 5% in 2013, but premium increases and cost cutting should improve net income. Aflac has adapted well to Japan's aging demographic, offering niche insurance policies and allowing policy entrants on some of its life insurance policies like EVER up to age 80.
AFL is predicting an average USD/YEN rate of 90 for 2013; I think this might be a bit optimistic, but underlying growth prospects remain strong and I trust that the company will continue to develop new products, raise prices, and cut costs.
US revenues were up 5.4% for 2012, and pretax operating earnings jumped 10.3%. 90% of Aflac's products are sold to small businesses, so small business growth will be imperative over the next several years. The ultimate effects of the Affordable Care Act are yet to be seen, but it's likely that small business employment growth will be relatively slow in 2013. This isn't a total game changer; small businesses should benefit from less uncertainty regarding the over-hyped fiscal cliff and general economic growth.
While some investors may be concerned with slowing sales growth, others are likely worried about the investment portfolio.
I've written in the past that the approximate $17 billion in the portfolio that is allocated to EU peripheral financial institutions is essentially risk-free. AFL has impaired or significantly written down the values of the riskiest holdings. Most importantly, the institutional debt that Aflac is invested in is issued by banks that are crucial to the international financial system and will be saved at all costs. These kinds of catastrophic worries are largely unnecessary anway; toxic assets have been transferred en masse to public balance sheets, where they're not subject to margin calls or default risks.
To take advantage of higher US rates, AFL has been investing in US corporate bonds, targeting BBB rated issues. It may be not happen quickly, but it appears that US rates are beginning to normalize. It should be noted that even moves like we recently saw to 2% on the 10-year US treasury can have a significant impact on Aflac's massive investment cash flows. The company generates about $14 billion in investable cash flow annually (and growing), and currently has an investment portfolio worth about $120 billion.
Over time, I believe gains from the investment portfolio will have a transformative impact on the bottom line. The financial crisis hit insurers like Aflac very hard, and the reality is that AFL was particularly exposed. That being said, management has shaken up its investment team and refocused its strategy.
The company is guiding for $6.37-$6.57 in 2013 earnings, based on an exchange rate of 90. At the midpoint, AFL is trading at a mere 7.9 times earnings, paying a 2.6% dividend that should get bumped at least 8% this year. Downside continues to appear exceptionally limited, even if sales growth may be comparatively soft this year. I recommend investors, particularly DGIs accumulate shares after Wednesday's post earnings selloff.