AFLAC: The Risk Is Being Out Of This Stock

The past three years have proven to be trying times even for the normally patient AFLAC (AFL) loyalists, in the midst of a scorching environment for financials in general and life insurance stocks in particular. Will the next quarter bring more bad tidings and show the recent pattern of a sales shortfall and an immediate selloff to the stock?

We don't know the answer to that one, but we do know that the same manic behavior benefiting the market in general has affected AFLAC, in the opposite way. Why should investors feel comfortable owning a stock like AFLAC (or buying on bad news) for the next ten years as opposed to a stock like American Express (AXP), which is making new highs every day, with considerable more intermediate term risk? Because the quality of the earnings stream virtually assures the company will report compounded growth in book value of 15% through 2012, while it is a virtual certainty that the payments/credit business will see a cyclical downturn (a decline in earnings and trough ROE) in the next three years.

Granted the company will no longer assure the market of the 15% to 17% earnings growth investors have become accustomed to, but there are several arrows in the quiver that could make this a lower risk alternative in a market for financials that now is priced for perfection.

We've always thought the counter-cylcial nature of its earnings sources, and hedging and investment income flexibility (courtesy of AFLAC Japan) to be undervalued (we always thought being fully shareholder equity hedged to be too conservative a strategy in the Nineties). The risk with AFLAC is being out of the stock, as the yield curve in Japan shifts upwards (gradually) through 2010.

In fact, the parallel is with the rather gradual upwards shift in the US yield curve since the post-9/11 events. That gradual rise in reinvestment rates we expect in Japan will allow the company to incrementally boost margins offsetting some of the slowdown in sales that now seem adequately factored into the stock price. The option is that Japan Inc. rises again as a regional powerhouse, with demand for financial and insurance products.

The persistence of erratic sales is the primary reason for the steep drop in the absolute and relative valuation versus peers. At 2.8 book value, the stock now seems as "cheap" as it has been in years, given the higher probability (70%/30%) that yields will move up several hundred basis points by 2010. That should give the company some time to "fix" some sales issues as the CEO in training (young Amos) gets up to speed.

AFL 1-yr chart: