Given the uncertainty in Europe and a low interest rate environment, many investors are naturally weary about insurers. I find that this negative atmosphere will only help drive high risk-adjusted returns when the fundamentals prove strong. This year is gearing up to be an inflection point for the overall stock market, since at stake is the issue of lower taxation to capital gains. As talks about capital gains tax cuts become more frequent, the S&P 500 is well positioned to rise in 2012. Aflac (AFL) and Cigna (CI) are currently rated a weak "buy" and a near "strong buy", respectively. Based on my multiples analysis and DCF model, I find meaningful upside for both financials.
From a multiples perspective, both are relatively cheap. Cigna trades at a respective 8.3x and 8.1x past and forward earnings while Aflac trades at a respective 11.2x and 6.6x past and forward earnings. This compares to a respective 11.7x and 9.3x forward earnings for Humana (HUM) and WellPoint (WLP). With its dividend yield of 3%, Aflac offers some safety, but this is more than offset by the exposure to European banks.
At the third quarter earnings call, Aflac's CEO, Dan Amos, noted strong results, particularly in Japan, which remains a catalyst going forward:
"I'm pleased with Aflac's overall financial and operational performance in the third quarter. I believe we've established a solid foundation toward achieving our annual operating earnings growth and capital strength objectives…
Aflac Japan generated strong financial results for both the third quarter and the first 9 months of the year. Revenue growth in yen rose 4.8% for the quarter and 4.1% for the first 9 months. Although investment yields declined on new money, we saw solid earnings growth for the quarter and for the first 9 months. We are particularly pleased with the tremendous sales momentum in the quarter. The new annualized premium sales rose 22.2% to JPY 42.3 billion for the quarter, which significantly exceeded our expectations. Even more impressive, production in the third quarter set all-time quarterly records. For the first 9 months of the year, total new annualized premium sales rose 13.9%".
While results may have been strong in Japan, I do not see investors coming away from the sidelines any time soon without a massive shift away from everything Europe. With that said, I believe that the market shares this attitude and thus downside is limited in this regard. Currency momentum stagnation and poor margin trends would, however, further drag down value. Ironically, the growth in Japan is shifting business to Child Endowment and WAYS, which offer lower margins than traditionally.
Consensus estimates for Aflac's EPS forecast that it will grow by 15.2% to $6.37 in 2011 and then by 4.6% and 6.8% more in the following two years. Assuming a multiple of 9x and a conservative 2012 EPS of $6.57, the rough intrinsic value of the stock is $59.13, implying 37.1% upside. If the multiple were to decline to 6x and 2012 EPS turns out to be just 3.3% below consensus, the stock would fall by 10.7%.
With a foothold in more than thirty different global markets, Cigna also has a meaningful upside story going for it. During the third quarter, it delivered solid results across all segments with the top-line growing by 6.5%. The acquisition of HealthSpring will open doors to Medicare and with a strong balance sheet, the company is well positioned to penetrate this market. I am further attracted to Cigna's unique consultative approach that establishes loyalty - not surprisingly, the Select segment grew by 14% in the fourth quarter.
Consensus estimates for Cigna's EPS forecast that it will grow by 13.3% to $5.28 in 2011 and then by 6.4% and 11.7% in the following two years. Assuming a multiple of 9x and a conservative 2012 EPS of $5.58, the rough intrinsic value of the stock is $50.22, implying 11.6% upside. However, a CAGR of 10.46% for EPS over the next three years discounted backwards at a WACC of 9% implies a fair value of $79.99. This huge discrepancy is inherent in the nature of the business. Fortunately, the low and high range both suggest just upside. Accordingly, Cigna merits its near "strong buy" rating.