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Last November I wrote an article covering the earnings of financials and noted that insurers did better than street estimate: here. Year to date insurers have outperformed the S&P by almost 10%.

I am interested in U.S. insurers since it is one of those sectors whose services are need-to-have, as versus discretionary consumption which, I'm not convinced, would have enough legs given the on-going deleveraging of American consumers.

Another reason for the market to favor the insurers is higher expectations for interest rates. Most of insurers' investment holdings are in long-dated fixed assets whose yield is at a historical low as the 10-year Treasury has slid from close to 5% in the middle of 2005 to 2.49% now. With Bernanke recently offering a firm timeline for tapering the Federal Reserve's asset purchase program, the 10-year Treasury yield has jump, bringing the year-to-date increase to 84 basis points. Insurers generate a lot of cash flows, which must be invested in fixed assets, and higher interest rates push up the yield on their investments.

Since insurers have outperformed the market, great companies at a significant discount are no longer easy to find. However, in my view, Aflac (NYSE:AFL) presented just such an opportunity.

Aflac sells supplemental health insurance which covers out-of-pocket expenses in the case of illnesses or accidents. At the end of 2012 it has annual revenues of more than $25.4 billion, 75% of which is derived in Japan. With its Aflac duck advertising campaign the company's brand recognition is high. It also does not seem to have a lot of competition since its products are unique.

However, Aflac has not participated in the insurers' rally this year.

The stock has historically tracked the performance of the Dow Jones U.S. Insurance Index, but started underperforming shortly after the first quarter of 2011. This is not surprising when we examine Aflac's earnings history in the last three years (see table below):

The company took a big impairment loss on its investment portfolio during the first quarter of 2011. As a result of "de-risking" activities, sale of holdings in certain European financials caused $579 million of realized investment loss pretax. This is part of the company's strategy of aggressively cutting down holdings of troubled European financials during the financial crisis, and in my view, is a conservative thing for an insurer to do. But the shares have suffered ever since then, even though the company has "de-risked" its portfolio significantly. Looking at the company's pre-tax profit margin (the top bolded line), we see that it tends to dip significantly in those quarters where there is impairment. The bottom bolded line shows the company's profit margin excluding net investment gain and losses, and this moves in a narrow range between 16% and 20%. In other words, the company's underlying insurance operations are more staid than one is led to believe by its earnings.

Aflac

(in $millions)

1Q2010

2Q2010

3Q2010

4Q2010

1Q2011

2Q2011

3Q2011

4Q2011

1Q2012

2Q2012

3Q2012

4Q2012

1Q2013

Premiums

4,348

4,333

4,607

4,785

4,872

4,956

5,210

5,324

5,378

5,467

5,660

5,643

5,184

Net investment income

726

727

765

789

794

784

843

859

882

845

869

877

833

Total net investment gains (losses)

(46)

(89)

9

(296)

(579)

(668)

(83)

(222)

(45)

(418)

286

(172)

156

Other income

37

9

13

15

30

16

17

18

25

8

32

27

35

Total revenues

5,065

4,980

5,394

5,294

5,117

5,088

5,987

5,979

6,240

5,902

6,847

6,375

6,208

Benefits and claims

2,857

2,885

3,102

3,263

3,222

3,310

3,517

3,700

3,646

3,763

3,932

3,989

3,521

Amortization of DAC

280

229

243

278

279

264

272

287

287

269

281

280

283

Insurance commissions

403

398

412

424

422

427

438

438

435

432

442

435

392

Insurance expenses

481

508

505

568

508

543

558

616

564

587

595

669

534

Interest expense

33

33

39

44

45

46

52

53

57

62

67

75

71

Other operating expenses

37

38

38

50

41

45

45

51

49

48

50

48

46

Total operating expenses

4,091

4,091

4,339

4,627

4,517

4,635

4,882

5,145

5,038

5,161

5,367

5,496

4,847

Earnings before income tax

974

889

1,055

667

600

453

1,105

834

1,202

741

1,480

879

1,361

Profit margin

19%

18%

20%

13%

12%

9%

18%

14%

19%

13%

22%

14%

22%

Pretax earnings exc. Investment gains (losses)

1,020

978

1,046

963

1,179

1,121

1,188

1,056

1,247

1,159

1,194

1,051

1,205

Profit margin

20%

19%

19%

17%

21%

19%

20%

17%

20%

18%

18%

16%

20%

Now the European periphery (i.e. Italy, Spain, Ireland, Portugal) represented only 3.32% of the company's global investment holdings. In my view, we should lower expectations for further impairments in estimating the company's earnings for the next few quarters.

Valuation

Assuming an average yen per dollar rate of 100 for 2013, year-over-year flat sales, and similar margins as last year, I estimated a full-year EPS of $6.1, including an impairment charge of $0.21, again similar to last year. It is not clear to me why the stock is trading at a much lower multiple than some of its peers such as Metlife and Prudential. Applying a multiple of 13 to my estimate would value the share at $79, a 36% upside to the current price.

One possible driver for the share's under-performance relative to the index is the share's correlation with the strength of the Japanese yen. Since most of the company's profit is derived in Japanese yen, any weakening of that currency causes its profit to be translated into less US dollars. The recent Abenomics and resultant expectations for weaker yen might have put pressure on the shares. However, according to the latest Big Mac Index, published by the Economist, purchasing-power parity values the Japanese yen at 81.41 per US dollar, so any expectations for further sustainable weakening of yen beyond what already took place might be overblown.

Source: Is Aflac's Undervaluation Relative To Its Peers Fairly Deserved?