Aflac at $80 is Just a Matter of Time

By Nikhil Shamapant - April 30, 2012 | Tickers: AFL, BRK-B, BRK-A | 0 Comments

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In my article on Aflac (NYSE: AFL)in March, I commented that Aflac deserved an $80 price tag due to the inevitable increase in earnings after a reduction in European exposure to their investment portfolio. Now I know Aflac's still not at $80...It's at $45, a 44% discount to $80, but I think Aflac's recent Q1 announcement makes it clear that Aflac has a glowing future ahead of it.

So Q1 was nice?

More than nice, it was phenomenal. First of all, earnings beat analyst expectations at $1.68, reducing Aflac's P/E ratio to 9 and possibly providing the means for a price increase to "normalize" the P/E ratio. But possibly more important was the guidance changes! You see, in my previous post, I mentioned that the earthquake in Japan wouldn't slow down Aflac's Japanese business. To conclude that paragraph I said, "Management believes there will be a modest decrease in sales next year(-2% to -5%), but nothing serious enough to merit long term growth concerns. " Frankly, it's a bit tough to convince your reader you're right when management still expects a decline in sales year over year. That all changed with Q1 Guidance though as management now expects full year sales to increase. If the Yen goes up to $85, Aflac reiterated its expectation of a low of $6.21 per share in earnings for 2012, giving Aflac a P/E of 7.24 for this year's expected earnings.

Can an old insurer like Aflac actually grow?

Aflac reiterated future growth expectations in this quarter, exciting me to no end. To close my March article, I gave you this management quote: "Once the effects of our investment de-risking activities and low interest rate yields on investments have been integrated into our financial results, we expect the rate of earnings growth in 2013 to improve over 2012." Well, this was reinforced again as management specifically mentioned expectations of higher 2013 growth. Aflac also mentioned they are working on creating a growth base in the US and are in the early stage of establishing US broker relationships, which bodes well for the future.

So it can Grow, It's a Value...Dare I Say Buffett?

Aflac has consistently achieved Returns on Equity around 17% and above, especially if you exclude investment gains and losses. Aflac's management has also consistently cared for its shareholders as the founder's son remains the CEO after a 22 year tenure. Aflac is a dividend aristocrat (it has increased or maintained dividends for the last 25 years) and has increased its dividends by an 18.8% compounded annual growth rate for the last 10 years. Furthermore, it has a large share repurchase program and is buying shares quickly while they are cheap. Ultimately, however, what is it that separates normal companies from those of the Buffett Quality? Competitive Advantages. How is the Aflac Duck better than Major Medical?(Other than being able to pull these sweet moves of course).

I believe Aflac's sustainable competitive advantage is in its Japanese segment. It has a near monopoly over other insurers in the country, and provides insurance for 90% of Japanese banks. Aflac also occupies a unique sort of niche. While the ads suggest otherwise, Aflac doesn't directly compete with major medical insurance such as WellPoint Inc or Cigna Corporation as its policies are designed to supplement this insurance and provide a safety net to defray nonmedical expenses. Aflac management does clarify that the scope of major medical coverage does limit their market potential, but Aflac has a lot of room left in its current markets before growth sources fully dry up. Aflac's business model, as an insurance business, also creates recurring revenues, making it more favorable as a Buffett style investment. Moreover, people love Aflac. It's on the list of the most ethical companies  and it is one of the top 100 companies to work for according to Fortune Magazine. In my humble opinion, these factors make Aflac worthy of Buffett and Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) portfolio.

Risks

With every bull thesis, it is crucial to mention the risks involved. For me especially, with my eagerness to support my prior article, I have to examine the risk potential for Aflac and try to level with myself on how risky those risks really are. So what are the major risks with Aflac?

1. European Exposure

I'll link to my article because Europe was the primary concern for that post. I detailed exposure to each company and I don't find the risk to be very significant. Management has been derisking and diversifying their investment portfolio which should reduce this risk significantly. Of course, things could get much worse very quickly...but I doubt it.

2. Japanese Exposure

With European exposure having caused such an issue for Aflac, the logical argument for any Aflac bear is to model the portfolio and attack their most concentrated holdings as a potential investment threat. The fact is, it is a potential worry. Aflac has 32.68% of its investment portfolio (as of Q1 2012) in Japanese Senior Debt. To be honest, I am no expert at macroeconomics or the study of the financial strength of a government body. What I do know is that S&P rates all Japanese debt as AA-. While I have my doubts about the reliability of S&P's ratings, a rating of AA- seems unlikely to default.

3. Strengthening of the Yen

As most of their business is in Japan, if the yen strengthens, it makes their business look bad. Aflac has projected, however, that earnings will have a low of 6.21 if the yen hits 85, and while the yen has recently surged, it is still unlikely that this will be a major threat to Aflac's earnings. Aflac management also explains that while they translate currency for the purpose of the financial statements, they actually reinvest yen directly, paying for bonds with those yen and therefore not actually feeling direct financial effects of currency. For a long term investor like me, I don't think currency poses a real threat.

Conclusion

I value Aflac at anywhere between $70 and $80 with low to no growth of Free Cash Flow; and with growth, price targets start getting ridiculous. Ultimately I trust management in its transparency and tenure with the company, I like the direction Aflac is going and the competitive advantage it has, and I am confident that Aflac shares will do extremely well in 2012 and 2013. 

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