This post was written by Bob Ciura on October 22 for Sure Dividend
Aflac (NYSE:AFL) has a long operating history, and is a giant in the insurance industry. Today, it provides insurance products to more than 50 million people worldwide.
But it wasn't always so big...
In 1955, John Amos and his brothers Paul and Bill thought of an idea to sell insurance products that paid cash if a policyholder got sick or injured. At that time, workplace injuries that resulted in disability were common, yet no product existed to help remedy this.
In the 60 years since, Aflac has done an excellent job of creating value for shareholders. For example, in the past 10 years, the company grew earnings by 8% compounded annually. This is very impressive when you consider that this period includes the Great Recession.
With its highly profitable business model and steady growth, Aflac is committed to returning cash to shareholders. It does this by repurchasing stock and also raising its dividend regularly.
Aflac is a Dividend Aristocrat and has increased its dividend for 33 years in a row. You can see all 50 Dividend Aristocrats here (stocks with 25+ years of rising dividends in the S&P 500). The Dividend Aristocrats Index has outperformed the S&P 500 significantly over the last decade...
Amazingly, Aflac has better total returns than the S&P 500 over the last decade as well. The reason this is amazing is because Aflac's price-to-earnings ratio fell from ~16 to ~11 and yet it still outperformed the market.
If the company's price-to-earnings ratio stays constant (or better yet, increases), Aflac will likely significantly outperform over long periods of time.
This article examines the investment prospects of Aflac in detail.
Aflac provides supplemental insurance. When a policyholder gets sick or injured and cannot work, Aflac pays cash to help them meet life's regular expenses. Aflac is the number one provider of individual voluntary insurance products in the U.S.
Investing in high-quality insurers (which Aflac is) at low price-to-earnings ratios (which Aflac has) is a powerful wealth compounding strategy. The story of Shelby Davis and his 23.2% CAGR can attest to that.
Most investors would probably assume Aflac does most of its business here in the U.S., given its well-known brand and its popular duck logo.
Source: Quote Addicts
But the truth is that Aflac does far more business in Japan than in the U.S. In fact, Aflac collects 75% of its premium income from Japan, and it insures one in four households in Japan.
Aflac maintains a clear growth strategy. Abiding by this strategy has fueled Aflac's impressive growth over its many decades of existence.
Source: 2015 Annual Report, page 3
The current business environment is a difficult one. The continuation of the Federal Reserve's low interest rate policy has kept a lid on Aflac's growth potential. The reason for that is because financial companies like Aflac earn less on their pools of invested capital when interest rates are low. As an insurance company, Aflac makes money in two ways.
First, it issues policies and collects premiums. The second way it earns income is by investing the large sum of accumulated premiums that have not been paid out as claims. This is referred to as the float.
Low interest rates weighed on Aflac last year. Aflac's net investment income fell 5.6% in 2015.
Still, despite low interest rates, Aflac is highly profitable. Aflac's operating earnings held flat last year, but Aflac still turned in earnings per share of $6.16. Its performance was even better if you adjust for currency fluctuations. Aflac's currency-neutral operating earnings per share would have increased 7.5% last year.
Aflac's growth is accelerating in 2016. Through the first six months of the year, revenue and operating profit grew 4% and 13%, respectively, year over year. In the key Japan market, revenue increased 8% through the first half of the year.
Aflac's major growth driver going forward will most likely be in Japan. That is because the company conducts most of its business there already, and the market fundamentals in Japan are attractive.
Source: Raymond James 2016 Institutional Investors Conference, page 4
Japan is seeing robust growth in demand for healthcare, which is flowing through to Aflac. In addition, Aflac has begun selling third-sector products there, which are non-traditional supplemental policies. For instance, one of Aflac's most popular third-sector product in Japan is cancer insurance given to customers who have had cancer before but have been cancer-free for at least five years.
On Aflac's most recent quarterly conference call, management stated that third-sector sales have come in well above expectations. Management expected third-sector sales would range from down 3% to up 2%. Last quarter, third-sector sales in Japan increased 11%.
A second growth catalyst for Aflac moving forward is rising interest rates. As discussed above, low rates have hurt Aflac over the past few years. But the Fed raised interest rates in December last year, which helped fuel But conditions have improved this year, thanks to the Fed's decision to hike rates last December. Over the first half of 2016, Aflac's net investment income increased 4.1% year over year.
Competitive Advantages & Recession Performance
Aflac performed admirably throughout the Great Recession of 2007 to 2009, given that the financial sector was the hardest hit market sector. Although earnings per share did dip in 2008, Aflac's premium income rose throughout the recession.
One reason for Aflac's recession-resistant business model is that life and health insurance are difficult to cut back on, even in times of economic uncertainty. As a result, Aflac's operations are not significantly impacted by recessions.
The company's earnings per share each year through the Great Recession of 2007 to 2009 and subsequent recovery are shown below to illustrate this point:
- 2007 earnings per share of $3.27 (new high)
- 2008 earnings per share of $2.62 (recession low)
- 2009 earnings per share of $3.91 (new high)
- 2010 earnings per share of $5.13 (new high)
Aflac currently has a low payout ratio of 26.5%. AFL's combination of stable (and growing) earnings and a low payout ratio make it very likely the company continues to pay rising dividends - even through recessions.
Valuation & Expected Total Returns
Aflac's stock presents a compelling opportunity for value and dividend growth investors. The stock trades for a price-to-earnings ratio of 10.6. This is significantly below the average price-to-earnings ratio in the S&P 500, which is 25.
Prior to the Great Recession, Aflac's stock traded at a price-to-earnings multiple of around 0.9x the S&P 500's price-to-earnings multiple. This implies a fair price-to-earnings ratio of around 22.5 for Aflac - more than double its current price-to-earnings ratio. As a result, Aflac is significantly undervalued.
I don't think Aflac necessarily deserves a price-to-earnings ratio of 22.5. What I do think is that the company is a bargain in today's low interest rate environment. Also, Aflac will likely see its earnings rise if (when) interest rates rise, unlike most dividend stocks.
Combined with Aflac's future dividend payments, investors will likely see either high-single-digit or low-double-digit total returns. The company's total returns will come from its 2.4% dividend yield, along with earnings-per-share growth. Earnings-per-share growth will come from both organic growth and share repurchases. Aflac has reduced its share count by over 3% a year over the last several years.
The company's dividend yield and share repurchases alone give investors a shareholder yield of over 5%.
Aflac is a blue-chip industry leader. It has a highly profitable business model, with several growth catalysts for the future.
Management is committed to rewarding shareholders with cash returns. Its cheap valuation will allow Aflac to buy back stock at very attractive prices, which will boost future earnings growth even more.
Aflac's stock is a compelling hold for value investors and dividend growth investors. It is a buy for investors looking for more exposure to the insurance industry. The company ranks well using The 8 Rules of Dividend Investing, thanks to its low payout ratio, low price-to-earnings ratio, and solid growth prospects.