Tuesday, May 24, 2011

This Huge Company's Stock is Ridiculously Cheap

There's something more to insurance giant Aflac (NYSE: AFLthan just the funny (and wildly successful) duck mascot.
Weighing in at a hefty $26.8 billion market cap, Aflac (originally the American Family Life Assurance Co.) writes supplemental health and life insurance in the United States and Japan. The company's products are marketed through multiple channels in both countries, which add up to 80% of the company's revenue. I'll discuss its distribution model in greater detail later because, to me, that's one of Aflac's greatest strengths -- especially as the health care environment in the United States evolves.
The company's products in the United States include cancer policies and various types of health insurance, including accident and disability, fixed-benefit dental and hospital indemnity. Other products include long-term care, short-term disability and ordinary life. In Japan, the products are similar, also including hybrid products and stand-alone, whole-life medical plans.
Leveraging a strong brand and breakout numbers equal investor success…
So while the Aflac duck continues to quack and entertain while strengthening the brand, the numbers do the real heavy lifting. In the past five years, revenue has risen from $14.4 billion to $20.7 billion in 2010, a 12% compound annual growth rate (CAGR). Not too shabby for a company that large. The five-year earnings per share (EPS) growth story is even better: a 13.9% CAGR through 2010. The average annual return on equity (ROE) has come in at a little better than 21%. Typically, 20% and northerly is an indicator of good things.
Thanks to the leftovers of the 2008 financial crisis, there has been some persistent concern for the mortgage-backed securities (MBS) Aflac holds in its investment portfolio. However, the company has done a superior job of risk management by lowering MBS holdings to 1% of the portfolio from 1.5% the prior year.
So far, Aflac has come out of the gate strong in 2011. First-quarter operating EPS came in at $1.63 per share, which handily beat the consensus of $1.41. There was also marked improvement in the company's U.S. business: U.S. sales growth for the first quarter of 2011 was positive for the first time in nine quarters. But keep in mind that the United States represents only 20% of the business. Japan pays the bills, and Japanese sales grew by 13% for the same quarter.
Speaking of Japan, saying "Aflac" and "investing" in the same sentence lately makes the "Nervous Nellies" break out in hives. Is there risk to Aflac's Japanese business thanks to the earthquake and tsunami? Of course there is. Enough to knock the stock back nearly 10% or so (see chart below) in the trading days following the disaster. Shares fell from the $56-55 range to $50 and some change.
Huge natural disasters and markets made of jumpy, reactionary, fearful, wannabe investors don't mix. That means luck for smart, cool investors. The stock price has recovered nicely back to around $56. If you were bold, you made a quick 10%. If you panicked, you're better off selling all of your equities now and buy a certificate of deposit (CD) paying a whopping 45 basis points.
A lot of the Japanese fear was probably overblown. Much of the confusion has dissipated. Will it affect the business? Most likely. However, holding shares of Aflac is still a good idea. Here's why...
U.S. sales have improved noticeably. Is that a sustainable trend? I think so. In the United States, Aflac's distribution model, like most insurance companies, relies on independent contractors. This is a cost-effective way to get the product out there, but is it the best idea for quality when a good, solid brand is involved? 20 years ago I would've said "no." But with its branding efforts in recent years, Aflac has also put a lot of work into recruiting higher quality representatives and investing in education and training. As a result, the company has a smarter, more professional sales force and is able to recruit prospective employees with higher skill sets. The result will be deeper product penetration and better client retention.
While Aflac's U.S. sales force will drive distribution, a true need for the product will also help, thanks to pending imposition of the Health Care Reconciliation Act (aka "Obamacare") on thousands of small businesses. For those that can only afford the bare minimum or can't provide coverage, Aflac can fill in the gaps.
Aflac's supplemental plans are typically purchased through payroll deduction and are very affordable. Premiums for lower-wage employees are often as small as $6 or $7 a week. That sounds relatively small, but when you consider the huge number of small businesses with employees who fit that description, the opportunity is equally enormous. With this on the horizon, U.S. sales could play a bigger part, especially if the Japanese business slows as predicted.

Action to Take --> 
 Aflac shares currently trade at around $56, with a trailing price-to-earnings (P/E) ratio of 12.6 and a forward P/E of 8.4 -- quite cheap for a business of this size. There's also a nice 2.1%dividend that the company has raised for 28 consecutive years. That's a bonus. To me, Aflac is a longer-term story.
Aflac's projected earnings per share (EPS) for 2011is $6.03. Based on that, the forward P/E is around 9.3. If the company executes, taking Aflac's 13% annual EPS growth rate into consideration, I think a 12-month price target of $71 is in line. This would equate into a 26% expansion of the earnings multiple (9.3 to 11.7) and a total return of around 29% for the stock price (throwing in the dividend).
Again, if the 13% EPS growth trend persists, 2012 EPS would come in around $6.81. The P/E would only need to grow by about 8% (12.6 times) for the stock to get to $81. That's 44% from where the stock is currently.

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