Aflac - A Corona Discount

Summary

• Today we take a look at the Aflac Corporation. While it's questionable how many "Corona Discounts" there are still out there, Aflac's valuation seems favorable.
• Aflac is a fundamentally appealing company with an excellent business and numerous long-term safeties.
• The company is currently a "BUY".

I like insurance companies - this should come as little surprise to those who follow my articles on this platform. Financials make up a significant, 15%+ stake of my portfolio, and a not-insignificant amount of this is made up of pure insurance companies.

Why?

Because in the end, most people in modern societies need some sort of insurance. It's not as basic a need as food, heat, and light - yet in a society that's structured as ours is, it comes close given its implications for healthcare, loss of financial capital, our houses, cars, etc. We want to feel safe with our "things," and insurance plays a major role in this. In the end, there are few things safer to invest in than products or services that cater to the human need to feel safe.

With that out of the way, let's look at Aflac (NYSE:AFL).

Aflac - What does the company do?

This isn't a company with a century-old history, but it was still founded more than 60 years ago as the American Family Life Assurance Company of Columbus (wow, long name). It was incorporated as Aflac in 1973 and as of FY19, insures over 50 million people in Japan and the USA.

Today, Aflac is found primarily in two segments of operation, categorized by geography.

Aflac US provides the American market with insurance products aimed at asset depletion protection due to accident, cancer, critical illness/care, hospital indemnity, vision care, dental, and other so-called loss-of-income products. Examples here include disability plans.

Aflac Japan provides the Japanese market with supplemental insurance plans/products aimed at things like cancer, general medical conditions, living benefit life plans, life insurance plans, and annuities.

(Source: Aflac Credit Suisse 2020 Presentation)

There is obviously a high degree of difference between the Japanese and American insurance market, which characterizes the respective organizations. Sales of insurance/products are made through associates and brokers, as well as independent companies or agencies. In Japan, for instance, insurance products are sold through channels such as banks (represented at 90% of total banks in Japan), Daido Life, Dai-ichi Life, the Japan Post (20 000 post offices nationwide), and more traditional channel agencies - 9000 in total.

(Source: Aflac Credit Suisse 2020 Presentation)

Making money in the insurance business is, on the face of it, simple. You first try to price your insurance products in such a way that you manage the risk you take for the specific plan or product in a way that guarantees you a profit on the policy.

If the total premiums over time are larger than the total insurance payouts, the firm generates a profit through this, and this is what's known as an underwriting profit, which we find in any insurance business on the planet. When I write about Sampo (OTCPK:SAXPF) (OTCPK:SAXPY), I often speak of the company's combined ratio - the combined ratio is the ratio of payouts over received premiums - which means that the lower combined ratio the company has, the better the performance is.

Aflac, when you look at the performance on a 10-year basis, has managed to keep the Japanese business at an around 79-80% combined ratio, and the US business at a slightly higher 81-82% combined ratio, both excellent and both better than Finnish peer Sampo.

This is not the only way Aflac or any insurance company worth its salt makes money, of course. When the company has a profit - the difference between premium payments from customers and claims from policyholders - the company will typically invest this difference it holds, called the insurance float.

A company like Aflac will, much like us, invest this capital in stocks or bonds to generate additional profits. Over the past few years, Aflac has typically held over $600M in such assets, most of which are invested into very low-risk securities, such as high-grade corporate and government bonds. The income from these securities is marginal, given the record-low interest rates around the world, but it's better than zero and having cash lying around doing nothing.

The fact is, Aflac's Japanese operations are vastly larger than its American operations. There can be said to be incredible growth potential in the American market for the company. Take a look below.

(Source: Aflac Credit Suisse 2020 Presentation)

As it stands, Aflac does not even reach close to 50% of its possible audience, given access to Aflac policies. The company intends to address this through strengthening sales channels, building Aflac Dental & Vision, and working on brand recognition as well as pushing enrollments.

Let's move to Japan for a moment. Given Aflac's vast exposure to this market, it's important to note just how popular it is. Supplementary insurance in Japan is extremely popular, and Aflac insures one of four Japanese households.

The fact that Aflac has such a market presence and also significant sales in the USA (while smaller, net premiums still amounted to almost $6B in FY19 alone) means that it can offer policies at a price point that cannot be matched by competitors. Because they can offer cost-effective policies, they're then able to retain and attract customers better than their peers - as the cost is one of the primary considerations when companies or individuals choose insurance. Because they are able to attract more customers, bringing more income, they also don't need to play fast and loose with their insurance float - such as investing the float in risky securities with 6-7% or higher yield. This, in turn, lends a better balance sheet and better overall security, which lends itself to a higher degree of stability, credit rating, and other metrics we know and love.

So, because Aflac has been around for so long, enjoys these market positions, and at least the Japanese market penetration, it can be said to be a very appealing company. Aflac has spent decades building its extensive networks of affiliates, including the strong actors mentioned above, and it would take competitors billions to replicate it, and the advantage it brings. Its history also means it has one of the best databases of actuarial data in existence, which allows the company to predict risk better than its competitors.

When considering this, it's easy to start to see how Aflac has become and is such an attractive, safe company and how it makes its money.

Management is another point in Aflac's favor. Typically, people in charge are with Aflac for years. Daniel Amos, the CEO of Aflac, has been with the company for 45 years, and we can likely expect the company's conservative traditions, which makes it such an interesting and conservative investment to continue.

Let's move to recent results.

Aflac - How has the company been doing?

The last results we have are not-as Corona-affected 1Q20 results. While most of the months were outside of Corona effects, the company went ahead and presented its corona response, which looks like this.

(Source: 1Q20 Presentation)

It pretty much aligns with what most other companies in the sameand similar sectors are doing - no surprises here.

In terms of Corona effects, Aflac saw effects primarily during the last weeks of the first quarter. The company estimates April sales to be affected by 50-65% YoY sales drop due to Covid-19 and people being unable to get to many of the physical sales channels.

Aflac is introducing multiple options for face-to-face sales and in order to preserve its existing market share.

(Source: 1Q20 Presentation)

However, core operations aside from sales are looking good, and as of 1Q20, the company had recorded no material 1Q20 COVID-19 claims and only 1.8M Yen in COVID-19 claims in the Japanese market. With expenses expected to remain stable in both markets, albeit with reduced customer activity, any effect on Aflac's underlying operations should be expected to be short, or at the most a medium-term sort of effect.

Underlying results during 1Q20 were good, with net investment incomes up $25M YoY versus guidance, and FY20 expected to be moderately ahead of given guidance. Given market trends, the company's variable investments, including the float, recorded a no more than $7M Net interest income, which is at the lower end of the expected income spectrum. The company also expects 2Q20 results to further reflect the valuations of public equity/stocks. However, overall Aflac's exposure to any sort of risk is extremely limited. Take a look at an updated picture from 2Q20.

(Source: 1Q20 Presentation)

And, let's also take a brief look at the company's portfolio exposure.

(Source: 1Q20 Presentation)

I mentioned above that Aflac has some of the most conservative practices on the market in terms of its investment, translating into excellent credit ratings and safeties. The company's forward focuses include defending the company's 37-year dividend increase record, and the company communicates that it has no intention of cutting.

The company has performed stress tests to measure the impact of a COVID-19 impact and has come out expecting a 0.5-1% impact on the Japanese benefit ratio, and a 3-5% impact on the US corresponding ratio, based on an estimate of 1.2-1.5M people hospitalized respectively in either country. Based on this, there is some uncertainty and some potential short-term impacts, but these are likely to disappear as we move forward.

A quick word on the Group's benefits acquisition of Zurich Groups American business. The integration of the business is on track and follows Aflac's current "buy-to-build" growth strategy, with expected benefits materializing over the coming years.

Aflac entered the COVID-19 crisis with plenty of available capital and an excellent overall financial position, with impressive near-20% or above 20% profit margins depending on the market. Aflac holds around $4.8B in cash as of 1Q20, $1.5B of which is in senior unsecured debt recently issued during March of 2020 at excellent rates of 0.62% and 3.6% coupons.

So, how has the company been doing?

We can expect more COVID-19 effects going forward, but in terms of underlying results, Aflac did quite well - or at least isn't in any danger going forward, which is reflected by the company's continued, stellar quality ratings. 2Q20 will likely bring more negative results, as negatives for 1Q20 were limited to Net EPS and RoE - with Adj. EPS growing 8% YoY and BV/share growing 5.3% YoY.

Aflac - What are the risks?

Despite being a stellar company, Aflac does face a few risks that bear considering prior to investing in this insurance company. Let's look at the ones i consider relevant.

• First, the company did face and is still facing the effects of a scandal in 2018, which exposed claims of fraud and abuse by Aflac against its employees, including such things as accounting manipulation, misleading investors, and general exploitation of the sales staff. Aflac went through the allegations and concluded that they were mostly false and without merit - but we should consider carefully whether such things bear more consideration. Let's remember Wells Fargo (WFC) and what the scandals did there.
• It would be irresponsible not to talk about the Japanese market. I mentioned that Aflac has a considerable dependency on its Japanese business - around 70-75% of yearly revenues. The Yen isn't the most stable currency, and it has been weakening as of late due to Japan government's aggressive fiscal policies. The risk here is that if the yen weakens, a highly-exposed company such as Aflac would see FX almost nullify or at least lower any sort of earnings growth.
• The company's previous growth record was built on the back of Japanese success. A repetition of this is not only unlikely, it's downright nearly impossible. Why? Because Aflac already has a high, 25% market penetration rate in Japan - and the demographic time bomb in the form of Japan's aging population combined with a minimal fertility rate means that the Japanese market will be shrinking. In fact, economists believe that Japan, as a country, may shrink by 34% in the next 70-80 years. The risk here is that Aflac's market will shrink, and therefore a repeat performance here will probably not happen. Aflac must find new growth avenues.

This concludes the risks to Aflac for the time being.

Aflac - What is the valuation?

Valuation on the other hand, is looking much better than risks. Take a look at a 10-year picture.

(Source: F.A.S.T. Graphs)

Aflac is a typical insurance company, in that the market doesn't typically like giving it any sort of close to fair-value-15X valuation, but rather hovers around 9-11. Corona has introduced a severe disconnect even from this, however, and despite recovering from the worst of it, Aflac is now trading at a blended P/E-ratio of 8.46X. The potential upside simply to its market-assigned discount based on 2020E earnings is as much as 25%. This might not have been much 2 months ago, but for a company like Aflac, it's very good even today.

Forecasting accuracy is near-flawless for analysts here, with only a 9% miss ratio (including a 10% margin of error), meaning we should be able to consider the earnings expectations for the next few years at least somewhat indicative. The potential upside on a 3-year basis given investment at today's level is fairly impressive.

(Source: F.A.S.T. graphs)

Essentially, by investing in one of the most conservative insurance companies on the market, you're setting yourself up to potentially outperform major indexes on a 3-year basis. For those of you considering the 3% yield too low, or the 15% annual rate of return too modest, I point you to the overall safeties of Aflac, which do not compare with its insurance peers.

In my way of viewing things, Aflac is an undeniable class 1 stock. It has an A- credit rating, a dividend considered exceedingly safe (and rightly so, given its sub 30% payout ratio), and its 37-year streak gives it a certain amount of safety. Morningstar doesn't give Aflac any sort of moat, which to me, is surprising given the company's market position. EPS yield is stellar at today's valuation, and all of this means Aflac scores a 3.5 out of 4.3, which is currently on the same level as Ameriprise Financial (AMP), another Financial Class 1 stock.

The drawback here becomes obvious when you look at expected EPS growth. Much like the company's Japanese business, the company isn't expected more than to maintain its current trajectory of 1-2% EPS growth for the next few years. This means that you're unlikely to go from modestly wealthy to rich investing in Aflac, at least in this amount of time, but we should also consider investments like this that safeguard our existing capital, providing a more than the adequate rate of return.

Aflac, as I see it, is one such company.

My fair value target for Aflac is 46/share, representing a ~10.4 P/E based on estimated 2020 earnings - and to this, Aflac currently offers a 25% potential upside.

That's good enough for an investment and a positive thesis.

Thesis

Investing in Aflac certainly won't make you rich in a long time. But it's an excellent place to stash your cash and watch them, most likely, slowly appreciate while offering acceptable dividends and rates of return in the meantime.

Aflac is very rarely as undervalued as we're seeing it now, and that in itself is an opportunity that I believe should not pass you by. In terms of its class 1 financial peers, only the Reinsurance Group of America (RGA) show a better valuation and yield - and that company is in a somewhat different business.

Every other financial stock that shows an appealing valuation is one I rate lower. While this doesn't make the companies uninvestable in any way, it beats justification going for a lower-class company that's cut or adjusted the dividend or has some other lack, before a class 1 company - at least how i see it.

So, with that said, I consider Aflac the most appealing insurance play of its kind available today - and at a 25% undervaluation, I'm a buyer. I believe you should be as well.

Thank you for reading

Stance

A 25% undervaluation makes the qualitative company Aflac a "BUY" with good upside in today's market.

Disclosure: I am/we are long AMP, AFL, RGA, SAXPF, SAXPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.