Selling Aflac Put Options
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
This is a part of my, Behind the Curtain: Special Situations for Explosive Returns, series.
Selling Aflac Put Options to Profit from Volatility
Aflac Inc. (NYSE: AFL)
Business: Aflac is an insurance company. It does most of its business by providing supplemental life and health insurance. Aflac is unique in that it pays its customers directly in cash upon injury rather than paying for their expenses, allowing customers to make their own decisions on uses of the cash.
The company has a unique economic moat in three main areas: 1) unique business model of giving cash to customers rather than paying for expenses allows customers to feel more satisfied with their use of their own money; 2) Aflac has huge brand recognition in the US and is a proud partner of the Heisman Trophy (something that I consider a game-changer); and 3) Aflac has almost complete control over the insurance market in Japan (“Aflac is the No. 1 company within this niche of the insurance world, and in Japan, where the company collects 70% of its revenue, Aflac insures 25% of households and employees at 89% of the companies on the Tokyo Stock Exchange.”- Jacob Roche, Motley Fool Writer).
Due to its involvement in the bond market prior to the European Debt crisis, Aflac has been hit hard by expected losses in its bond portfolio. However, management has recently gone through an extensive ‘derisking’ process, and these bond losses should be a one-time expense. Also, Aflac is on track to have earnings of 6.66 per share next year, giving it a forward P/E of 6.2. For a company like Aflac, which has consistently achieved an ROE of 15% or above for the last 10 years and has a brilliant and transparent management led by the son of Aflac’s founder, Daniel Amos, Aflac should rise as investors realize the low Europe-related risk that Aflac is exposed too.
My discounted cash flow analysis shows Aflac’s undervaluation as well. I conservatively assumed that AFL would not grow its FCF in the next 10 years, and that AFL would not lose FCF in the next 10 years. Using a conservative P/S exit multiple of 1 (which assumes that after 10 years Aflac will only maintain FCF for one more year and go out of business), the intrinsic value of Aflac Inc. was found to be $60, an undervaluing of 31%.
However I also redid the study using more realistic measures: a FCF growth of 2%, Discount of 15%, and the exit multiple of Price to Cash flow. This yielded an intrinsic value of $81, an 49% undervaluing. This is not hard to believe as if AFL was priced this way now, it would have a forward P/E of around 12, which isn’t that expensive considering this is 10 years into the future.
Ultimately, this gives me the impression that Aflac is a great opportunity for a stock investment. However, due to the volatility surrounding Aflac’s stock, the most profitable investment at this time would be to sell Aflac put options, as they seem to have a lot of expensive time value for put writers to profit from.
As Aflac is such a great stock investment at current prices, I would encourage investors to enter the stock by selling a Jan. 13 2013 Put option with a strike of $40, for $7 (Bid6.9Ask7.05Volume0OpenInt1407). This would give investors a stock position with a starting price of $33, or if the put options are never exercised, as I believe they will not be, it will put $700x#of contracts sold in an investor’s pocket. Know that the only risk associated with this trade is the risk of buying shares of Aflac, which you would be obligated to buy at 100 shares per contract.
Tracking the Series: As of 12/21/11 NOT day of posting.
1.Shanda Games: +27.1%(includes dividend)
2. Cohesant Inc.: +.1%
3.El Paso: +3.4%
4. Aflac Naked Puts: Assuming Exercise on Dec. 19th, +26.4%, with no exercise, +$700x#of contracts
Fool Blogger Nikhil Shamapant is net long in shares of Aflac and has not executed a trade in Aflac within the last two trading days.
