- Aflac does most of its business in Japan.
- Consequently, the value of the yen has a large effect on Aflac’s reported earnings.
- On a currency neutral basis, the company has been performing well.
Aflac (NYSE:AFL) is a world leader in supplemental insurance. The company operates in the United States and Japan, with the vast majority of its business coming from the latter. Aflac sells a variety of life and supplemental health insurance policies. The company covers more than 50 Million people worldwide. As seen below, Aflac's share price has been stagnant over the past few months. Before beginning a more detailed financial discussion, it's important to mention that in the financials, results from Japan are translated into dollars for reporting purposes. In reality, most yen are not converted into dollars. Uncertainty surrounding Japan has been hurting Aflac's share price for quite some time.
In 2013, revenue fell by 5.62% and net income increased by 10.19%. Operating earnings, a key measure of the company's profitability, fell by 8.58%. Operating earnings are a non-GAAP measure that excludes certain items that cannot be predicted or are outside of management's control. For Q1 2014, revenue fell 9.15% and income fell 17.94% when compared to Q1 2013. The substantial decline in net income can largely be explained by differences in realized investment gains. Proving this, Aflac's Q1 2014 operating earnings remained unchanged from Q1 2013 levels. However, as mentioned in the previous paragraph, looking at Aflac's reported financial numbers is not enough. Since roughly 75% of Aflac's business comes from Japan, exchange rates have a major influence on the numbers that end up on financial statements. As a result, investors need to scrutinize the effect of foreign currency on operating results. This is especially important when you consider that the yen declined around 18% in 2013. Currency changes lowered 2013 net income by $312 Million. Excluding the impact of currency, Aflac's 2013 operating earnings per diluted share rose 5.2%. In 2014, the company hopes to increase its operating earnings by between 2% and 5% before the impact of foreign currency. Since the company has historically converted a limited amount of yen, the currency neutral view paints a more accurate picture of Aflac.
Aflac currently trades at 1.81x its book value. As shown below, Aflac usually trades at a higher price to book multiple than it currently does. The company also has a ROE above 20%. Looking again at the graph below, this seems normal. Management announced that for Q1 2014, the company's annualized ROE was 26.0% when excluding the impact of the yen. When looking at insurance companies, it is also important to evaluate the Solvency Margin Ratio, or the SMR. This measures an insurance company's ability to pay out claims even when unexpected events occur. For Q1 2014, Aflac estimates their SMR is above 750%. Management has stated that Aflac's SMR will likely not fall below 500% to 600%. Recently, the company announced that it would be tying repatriation to its SMR. With that in mind, Aflac looks to convert around 127 Billion Yen this year. Among other things, with this money, Aflac plans to repurchase between $800 Million and $1 Billion worth of its common stock. Aflac also pays a consistently increasing dividend.
While I vehemently disagree, one argument against Aflac is that the Japanese government may default on its debts. Some believe that the country's debt is unsustainable and that Japan will eventually default. My main problem with this is that Japan controls its own currency and holds debt internally. Since Japan cannot run out of yen, any default would be the government voluntarily deciding against repaying its own people. Looking at this from a broader perspective, magnitude of such an event becomes apparent. We are talking about the default of a major industrialized nation. This is unprecedented and would likely result in widespread ramifications. It's absurd to think that a Japanese default will impact only the people of Japan and companies that do business there. The stability of other indebted nations will be immediately called into question. In order to be protected against a Japanese default, investors will have to do a lot more than just avoid Aflac.
I'm no currency expert, so I will spare you any projections about future USD/JPY exchange rates. I recognize why some investors focus on the strength of the yen, but I don't believe it is the end all be all of Aflac's future. Inflation and a weaker yen are two of the biggest worries surrounding Aflac. Could Japan see an uptick in inflation? It certainly could, but Japan is a country that has been trying to combat deflation for many years. Could Japanese inflation have a negative impact on Aflac? Yes, because inflation typically harms those holding fixed income investments and weakens currency. Do currency changes have an impact on Aflac? This is a much tougher question to answer. As shown earlier, currency changes most certainly affect reported numbers, but most yen are not converted into dollars. According to their most recent annual report, Aflac converts currency once a year and they have hedges in place to facilitate profit repatriation. Aflac Japan also holds around $20 Billion worth of dollar denominated assets which are hedged back to yen. The company has additional investments in reverse-dual currency securities. These are denominated in yen, but pay interest in dollars. Finally, I think it is important to realize that currency fluctuations are not new to Aflac. Over the past ten years, one dollar has been worth between 75 and 125 yen. Changes in the exchange rate have recently held back Aflac's reported income, but they can just as easily boost earnings should trends change. I must admit, I find it slightly peculiar that exchange rates are so heavily emphasized when looking at Aflac.
A Seldom Discussed Catalyst
I believe many overlook the possibility of further American health care reform when discussing Aflac. Before anyone accuses me of excessive speculation, remember that the central argument against Aflac is that the world's third largest economy may default. Looking at other industrialized nations, I would say there is a fair chance that the United States will one day provide universal healthcare to its citizens. Currently, individuals can shop around for a wide variety of primary health care plans. In a market where the government provides all with a basic level of primary care, it stands to reasons that there would be increased demand for secondary insurance. Since secondary insurance is Aflac's specialty, the company has a tremendous amount of experience in this sector that its competitors cannot match. It's tough to say exactly how much new business will be created, but it seems reasonable to guess that Aflac could do at least as much business in the United States as they currently do in Japan. A move towards government provided primary care in the United States would help the company tremendously. Aflac currently does most of its business in Japan, but there's no guarantee that this will always be the case.
Aflac is a quality company operating in somewhat of a niche market. It's important that Aflac owners recognize this and believe in the company. I cannot stress this enough because there is no telling how long fears about Japan will persist. For whatever reason, the discussion surrounding Aflac seems to focus only on negative potential outcomes. Very little is mentioned about the company's strong business model or positive catalysts. To those still concerned about exchange rates: In a scenario where Aflac's results are lower in yen terms, but their dollar value rises due to a stronger yen, would you be more likely to invest in Aflac? If not, I don't believe you should allow improving results masked by a weaker currency to paint the company in a negative light. Aflac is a profitable insurer being held back by issues over which it has little control.