By Drew Woodbury
Aflac (AFL), one of the highest-quality insurance companies and among the few to which we award an economic moat, is currently trading at a discount to both historical multiples and our fair value estimate. The company's business model in Japan is one of its strengths, as a loyal customer base, high retention ratios, and a low-cost sales model help it produce strong returns on equity. On the other hand, the unique, long-duration liability profile of this business combined with the lack of a long-dated corporate bond market in Japan forced Aflac to turn to the euroyen market and other European issuances to match the cash flows of the claims payments. As a consequence, the company has substantial exposure to troubled European sovereigns and financial institutions. While the company is making the right steps to de-risk its portfolio, the uncertainty surrounding the eventual outcome of the situation in Europe gives us pause. That said, given the historically low valuation, this might be an attractive entry point for investors with a more positive (or even neutral) view on the region.
Aflac Is a High-Quality Insurer
In general, we do not like the life insurance business model. Intense competition, commodity products, and losses that take a long time to realize cause us concern. One exception is Aflac, which is often classified as a life insurance company, although its main product is actually supplemental insurance. The company routinely generates returns on equity consistently in the upper teens, driven by its first-mover advantage and fierce loyalty in Japan, its primary market. Additionally, it has a low-cost sales model from marketing its products through the workplace, and customers have little incentive to switch. We believe Aflac has one of the best operating models among all of the insurance companies we cover.
Because of the high returns on equity the company generates, it has traded at an average price/book multiple of 2.7 times during the past 10 years. Currently priced at 1.5 times book value, Aflac is trading at a substantial discount to our fair value estimate, but given our concerns about its investment portfolio, we think it is appropriate only for risk-tolerant investors. Because of the 95% retention levels that the company routinely enjoys in Japan (one of the strengths of its business model), Aflac is forced to match long-dated liabilities with similarly long-duration assets. Additionally, these liabilities are in yen, requiring the company to purchase yen assets to properly match the currency of the cash flows. The problem that arises is that Japan does not have a deep long-dated corporate bond market. The primary method of financing for Japanese companies is bank debt, so the only publicly traded domestic bonds tend to carry maturities of less than 10 years. In order to match both the currency and duration of its liabilities, Aflac historically has turned to the euroyen market, where the primary issuers are European banks and financial institutions. Since the European debt crisis began, the company has diligently worked to reduce its exposure to these assets, but it still retains direct and indirect exposure to troubled European countries as well as their locally domiciled financial institutions. The company has not specifically disclosed its indirect holdings, but noted in its 2011 10-K filing that in aggregate it held $10.1 billion (75% of book) in exposure to European financials, $4.3 billion (32% of book) in periphery eurozone utilities, and $7.4 billion (55% of book) in periphery eurozone industrials, at amortized cost, as of Dec. 31, 2011. Given the size of this exposure, a capital raise cannot be ruled out if the situation in Europe deteriorates. As a consequence, we recently increased our fair value uncertainty rating to very high from high as we believe investors should require a wider margin of safety before purchasing Aflac's shares.
Furthermore, the company's holdings of perpetual securities, which came under stress during the financial crisis, remain a question mark. These securities are in a unique position in financial institutions' capital structure, somewhere between debt and equity instruments. As some financial institutions were nationalized or near bankruptcy, investors began to wonder if these securities would be wiped out entirely (like equity) or would remain in place, similar to other debt holders. Again, the company has been working to reduce its exposure to these securities, especially those domiciled in the most troubled countries. But if markets deteriorate, these investments could come under considerable stress again. Of the perpetual securities listed below, 69% are from companies based in Europe, excluding the United Kingdom. Additionally, the U.K. represents about 9% of the amortized cost, with Japan and others constituting the remaining portion.
Aflac's Capital Position Creates Some Cushion
The company currently has a relatively strong capital base. At the end of the first quarter, management estimated that its risk-based capital ratio stood between 500% and 540%, a very strong number indicating that it has excess capital. Additionally, the direct exposure to Portugal, Ireland, Italy, Greece, and Spain is not very large relative to the company's capital position, and in general, its European financial institution debt is well protected by the seniority of its claims. Finally, we believe the company has tried to get in front of the situation as much as possible by reducing its riskiest exposures in recent quarters.
In our opinion, these investments are not indicative of a lack of risk management or a warning sign that the company has been too aggressive with its portfolio in order to gain incremental returns. Rather, Aflac's unique business model and cash flow profile in Japan necessitated these investments, to some extent. In hindsight, other alternatives may have been preferable, but we do not believe the company should be faulted for the investment choices it has made.
That said, certain European investments remain and the unique cash flow situation will not disappear, which will probably necessitate either similar purchases in the future or for the company to seek an alternative (and possibly lower-return) investment strategy. Still, assuming the company can make it through this situation without major investment losses or a capital raise, there could be substantial upside for investors. As a result, we think the shares could be attractive for risk-tolerant investors with a bullish or even neutral take on the European situation.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.