Aflac (AFL) and its namesake duck are no stranger to dividend growth investors, but what are the driving forces of their success and how likely are those advantages to persist in the face of ceaseless market competition?
Aflac is one of the world's largest and most recognizable insurance companies. The company operates in only two markets, the US and Japan, which taken together have more life insurance policies in force than the rest of the world combined.
Insurance is generally categorized as a commodity business, because there is little product differentiation and consumer purchases are typically based on price. While Aflac offers a variety of products it is most well known for supplemental insurance. These policies are focused on covering everyday expenses that are not typically covered by traditional insurance policies.
The Amos family founded Aflac in 1955, there is still significant family presence in the management, and they own approximately two percent of the company. The company has increased dividends for 29 years and is considered shareholder friendly. In November of 2011 Aflac hired former Goldman Sachs (GS) manager Eric Kirsch to oversee its massive bond portfolio.
Aflac's economic moat is driven by three factors: (1) first mover advantage (2) efficient cost structure and (3) inefficiencies in the national healthcare system. I know I left brand equity off the list. I much as I love to see Yogi Berra talk to a duck, anyone with money can put a mascot on TV. Lots of people loved the pets.com sock puppet too, but that only takes your business so far.
Aflac was one of the first companies to enter the Japanese insurance market and has put that first mover advantage to good use. Rather than selling to customers on an individual basis, Aflac offers its products through the workplace, where it can target large groups of employees at once. The company provides its customers with the option to have their premiums deducted directly from their paychecks and also allows customers to transfer policies from employer to employer, which helps keep retention rates high. The proof that these simple sounding strategies have allowed Aflac to set itself apart from the competition is evidenced in that about 90% of all companies listed on the Tokyo Stock Exchange offer Aflac products and more than 25% of Japanese households have at least one policy in force.
Keeping costs low is important to Aflac because this is what allows the company to maintain its dominant market position. If a competitor could charge lower premiums, than Aflac's other competitive advantages become moot. In addition to selling policies to larger groups through the workforce, Aflac was also one of the first companies to go paperless (almost paperless, let's be realistic). Driving down administrative costs per policy and overall low expense ratios allow Aflac to reap greater profits and charge lower premiums to customers.
Japan has a national healthcare system, however there can be significant gaps in this coverage. As most investors know by now, Japan has one of the oldest populations and it is only getting older. As the population ages and the birth rate decreases the national healthcare system comes under increased pricing pressure. As co-payments increase under the national care system, Aflac's products become increasingly less optional for the aging workforce. Essentially, because one can predict that the Japanese healthcare system will remain underfunded, one can also thus predict an increase in demand for supplemental policies.
Does the same thesis hold true for Obamacare? Much as Walmart (WMT) drives down prices from vendors through collective bargaining strength, there are many areas in which a national healthcare system actually works. Bulk pills, medical devices and (more or less) standardized medical procedures come to mind. However, corporate incentives being what they are, most companies are going to look for ways to pass off medical expenses onto employees regardless of the system in which they operate. Therefore, it stands to reason that there will continue to be a need for supplemental insurance policies regardless of the path that the US healthcare system eventually wanders.
As anyone who is a regular reader of SeekingAlpha can attest, it is a widely held opinion that Aflac's stock price is being held back by concerns of a devaluing Yen and a bond portfolio potentially exposed to troubles in both Europe and Japan. My two cents on this particular debate is that neither of these issues is directly related to the quality of Aflac's underlying business strength and that these matters will almost certainly average out over the long haul. For example, Aflac could partially institute a yen carry trade in either euros or dollars to help normalize earnings.
Aflac currently trades at very attractive P/E and P/B ratios both absolutely and relative to the company's historical norms. This valuation is supported by a better than 2.5% dividend that will only grow with time. Aflac falls under the umbrella of a Charlie Munger type investment; a wonderful company at a fair price. I believe that the quality of the underlying business more than compensates long term investors for exposing themselves to currency or bond risk.
First mover advantage in Japan
Low cost structure
High customer retention
High market share
Low interest rate environment
Negative demographics in Japan - declining birth rate and slow economic growth
US life insurance segment lacks advantages enjoyed in Japan
Inherently a commodity type business
Underfunded national healthcare system in Japan
Increased demand for supplemental policies from rising healthcare costs
Positive demographics in Japan - aging population
Adoption of national healthcare system in US
New entrants in both Japan and US markets
Bond portfolio exposure
Exchange rate exposure