While the broader equity market has performed exceptionally well since bottoming out on June 3 (the SPY is up 16%), Aflac (AFL) has been a remarkable market outperformer, up 32% over the same period.
At the time, Aflac was sold particularly hard in response to worries regarding its investment portfolio, which has $17 billion in total EU peripheral exposure. With an aggregate investment portfolio value of almost $110 billion and a market capitalization of $23.25 billion, this figure is by no means negligible.
That being said, investors continue to overstate the risks buried within the investment portfolio, and understate Aflac's cash generating abilities and long-term prospects.
Aggressive Sales Growth
Aflac does about 75% of its business in Japan, which explains why such a large portion of its investment portfolio is denominated in Yen. Japanese sales have catalyzed huge earnings growth over the past few years, and this year's projected revenue growth is nothing short of spectacular. Though initial guidance was for flat to 5% sales growth, Aflac's management just recently revised this figure to 20-25%.
Driving this elevated sales growth is a variety of innovative products. Aflac owns 50% of the market for new cancer insurance business, and its new DAYS product has been a huge success. DAYS is a base product for cancer insurance, a market that grew rapidly as a consequence of Japan's new Cancer Control Act.
Aflac's WAYS product, which generates a premium (.pdf) that ten times higher than its average health insurance product, is a "hybrid whole-life product that can converted to a fixed annuity, medical care coverage, or nursing coverage when the policy holder reaches a predetermined age."
Aflac's Japanese insurance products are primarily distributed through banks' sales channels, which is beneficial for both parties thanks to lower costs for Aflac and premium generation for banks. Aflac is represented by more than 90% of all Japanese banks, offering a huge competitive advantage.
Management expects US 2012 premium sales growth to come in between 3% and 8%, though first half results of 3% reflect the likelihood that full year revenue growth will be towards the lower end of that range. US revenue growth increased 5.2% in the first half.
On a bottom line basis, Aflac expects to earn about $6.48 in diluted EPS for 2012, assuming an exchange rate of JPY 80. This guidance was reaffirmed in last week's analyst/shareholder conference call, and management is guiding for 2013 operating EPS growth of 4-7%. Operating EPS strips out investment income.
Investment Portfolio In Strong Shape
I recommended purchasing shares of AFL at $43.50, particularly for dividend growth portfolios. In that article, I focused on AFL's investment portfolio, and broke down the true risks of sustained capital losses.
What I found is that Aflac's portfolio is actually exceptionally low-risk, with 80% of the holdings in AA or higher-rated securities. While $17 billion is allocated to European peripheral financials, AFL has already aggressively impaired or sold its riskiest assets, and it believes that these securities are largely protected by the implicit backing of sovereign governments. In other words, the issuers of these securities are very likely to be able to obtain favorable financing in the event of liquidity shortage.
Aflac recently had Goldman Sachs' asset management team review its portfolio and advise it on future allocations. The key takeaway is that Aflac is going to substantially reduce new flows into JGBs (Japanese government bonds) and invest more heavily in US dollar denominated corporate bonds. Of major importance is that AFL will now also target BBB issuers to neutralize the inherent hedging costs. These new money flows result in returns closer to 6%, far better than returns offered by JGBs.
50% 12 Month Upside
Assuming 2012 EPS of $6.48 and a current share price of about $50, AFL is trading at a mere 7.71 times earnings. Aflac's insurance business and net investment income has produced almost $14 billion in free cash flow over the last four quarters, nearly all of which has been reinvested in the investment portfolio.
The five-year average P/E ratio is 14.5, almost double the current valuation. The market appears to be dramatically overstating the risks within the investment portfolio, and understating both the increases in new investment yields and organic premium sales growth driven primarily by exceptional Aflac Japan performance. Aflac has retention rates of 95% in Japan thanks to its exceptionally large presence and "share of mind."
The last few years have resulted in massive EPS and free cash flow growth and a contraction in valuation in multiples - an intriguing combination for value investors. As the European situation drags on (and toxic assets get transferred from the private to the public sector), the US economy continues to grow at moderate pace, investment yields improve, and new high-premium products are rolled out with exceptional results, the market will be unable to keep AFL's valuation so suppressed.
An investment in Aflac offers a stunningly asymmetric return profile, and multiple expansion in the order of 30% would deliver significant alpha to investors. Over time, I expect the market to start valuing shares of AFL at 10-12 times earnings, reflecting a difficult (but manageable) rate environment, a modestly improved employment situation, and favorable competitive advantages. At 10 times 2012's earnings, Aflac would be trading at $65, roughly 30% higher than current prices.