Should Aflac Be Your Next Buy?

A week ago, I took up the challenge of corralling my easily distracted brain long enough to dig into five stocks that look very promising. Thus far, I've taken a close look at four of the five stocks that I highlighted:

Today, I'll round off the five with a dive into the ducky world of Aflac (NYSE: AFL  ) .

Aflac: What it is, jive turkey
For those familiar with the insurance industry, Aflac's business is immediately familiar. Like any insurer, Aflac's business is taking on a certain financial risk for its customers in exchange for an upfront payment. Like other insurers, Aflac makes its profit in two primary ways. First, when it does a good job pricing the risk that it's assuming, it gets to pocket some of the premiums it collects. Second, since it collects payments up front and pays out for claims later, the company can invest the premiums it collects and keep the investment returns.

But it's the specific type of product that Aflac offers that sets the company apart. In Japan, the company's business is largely weighted toward supplemental medical coverage, including cancer-specific insurance, while its U.S. business offers supplemental coverage that can help defray non-medical costs as well.

The market for supplemental insurance is not nearly as big as the traditional health insurance coverage offered by companies like UnitedHealth Group (NYSE: UNH  ) and WellPoint (NYSE: WLP  ) . However, when it comes to large, standardized insurance markets like health, auto, or life, there is far more competition and fighting for customers can often come down simply to pricing. There are still great businesses in those industries, but selling a commoditized product can be brutal.

So while Aflac's niche sacrifices overall market size, its focus has allowed it to become the 500-pound gorilla in its specialties in both Japan and the U.S.

Forget the U.S.
We certainly don't want to completely ignore the U.S. when it comes to Aflac's business -- particularly its future. However, if you're looking for a starting point for understanding the company, the U.S. isn't it. Why do I say this? For the first six months of the year, the pre-tax operating income of the company's U.S. division was $499 million versus $1.9 billion for its operations in Japan. Not only that, but with a 21.7% operating margin, Aflac's Japanese arm is also more profitable.

This heavy exposure to Japan comes with a number of positives. Japan is facing the problem of a government-run health-care system trying to deal with an aging population. That has the potential to put a greater burden on individuals, which would make Aflac's policies even more attractive. Culturally, Japan also tends to be more financially conservative, and this is good for both Aflac's health-related policies, as well as its flexible life-insurance policies that provide benefits for things like a child's education.

The exposure to Japan is also advantageous because it's … well, not the U.S. Diversifying your portfolio beyond your home shores can help your portfolio better weather tough economic times in the U.S. Similarly, for those concerned about the state of the U.S. dollar, Aflac's business in Japan is conducted in yen; so when the dollar is stumbling, earnings in Japan end up looking even better.

Of course, the Japanese exposure isn't all good news. Mr. Market may be more concerned about the U.S. economy than Japan's, but Japan isn't exactly the shining light of global economic growth. The country has also had an interesting political scene as it seems to go through a new prime minister every fortnight or so.

Forward-looking statements
It seems like there are few guarantees except change when it comes to the future of health care and health-care finance. In the U.S., whether you're Aflac or a traditional insurer like UnitedHealth or WellPoint, the concerns over unsustainably high health-care spending are almost certainly going to bring big changes in the years ahead. In Japan, the country's aging population and fiscal position could also bring changes to the way health care is paid for.

While these changes could mean challenges, it could also mean new opportunities, particularly for a company like Aflac. As a provider primarily of supplemental coverage, many of Aflac's plans pay a fixed amount to the insured, as opposed to requiring the company to pay for some specific medical procedure that could rapidly increase in price. This is a positive for Aflac, but it is also a positive for customers looking to a way to make ends meet when the government or a private insurer isn't shelling out enough to cover the full cost of a health-care issue.

Of course, we do also have to keep in mind that we're talking about two developed-world countries with economies stuck in the mud. Until the economic picture begins to brighten, it could be more of a struggle for Aflac sales agents to convince consumers that they need to shell out for an insurance policy outside of the standard fare.

Is there value?
The short answer is "yes."

If we stack Aflac up against other insurers, we find that its forward price-to-earnings ratio of 5.7 is a steep discount to the multiples of 11 and 8.9 that we find, respectively, with UnitedHealth and WellPoint. Fellow health insurers Aetna (NYSE: AET  ) and Humana (NYSE: HUM  ) carry similar multiples that are well above Aflac's.

Aflac's valuation appears more in line with the big life insurers, but even there it appears to be selling at a discount. MetLife (NYSE: MET  ) has a current forward P/E of 6.2, while Prudential Financial's (NYSE: PRU  ) is 7.

But perhaps we don't even need to go to the trouble of comparing Aflac with these other companies -- as I pointed out yesterday, the company's one-year and normalized 10-year multiples look attractive on an absolute basis. The 11% annual growth Wall Street analysts are expecting may be a bit optimistic, but with the market giving the company so little credit, stellar growth isn't necessary for attractive returns here.

Should you quack along?
The purpose of all of this research hasn't been just because I love reading SEC filings (though I do). Rather, I'm trying to decide which of these companies I should put at the top of my buy list to add to my personal portfolio. Aflac has made a strong case here, but it's competing against a tough group of attractive companies. To stay tuned for my final decision, you can keep an eye on my Motley Fool article feed.

In the meantime, though, hopefully I've given you a lot to think about here. As you digest this and dig into the numbers yourself, you should go ahead and add Aflac to your watchlist to keep up with what's going on at the company. Don't have a watchlist? You're in luck -- you can start one for free by clicking here.

The Motley Fool owns shares of Aflac, UnitedHealth Group, and PepsiCo. Motley Fool newsletter services have recommended buying shares of Aflac, Home Depot, WellPoint, PepsiCo, Exelon, and UnitedHealth Group. They have also recommended creating a diagonal call position in UnitedHealth Group, a covered strangle position in Exelon, and a diagonal call position in PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (3) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 02, 2011, at 5:23 PM, aaanglemyer wrote:

    I agree with the author that AFL is a great buy opportunity. Aflac's management has proven that they can effectively allocate capital with historical Returns on Invested Capital ranging from 13.7% to 20% over the past 13 years. The company has also been a cash generator over the past 10 years.

    Now, Aflac did generate a negative $23.75 million of Free Cash Flow in 2010 but this should not deter investors. Investors should view the negative Free Cash Flow in 2010 as an investment in Aflac's future since the decrease in FCF was not due to a decrease in NOPAT, which increased by 59.5% in 2010, but rather capital expenditures to expand the business.

    Given Aflac's ability to earn double digit returns on its historical Invested Capital, it is logical to assume that they will be able to earn similar returns on their expanded Invested Capital.

    Check out the following link for more information on how to identify good investment opportunities:

    http://blog.newconstructs.com/category/investing-101/

    Disclosure: I am employed by a research firm that is affiliated with a hedge fund that owns AFL. I receive no compensation to write about any specific stock, sector or theme.

  • Report this Comment On September 04, 2011, at 12:39 PM, GW1000 wrote:

    Matt:

    I find it interesting that AFLAC performs so well in Japan compared to the US. Why is this and are there any competitive risks to the Japan market such as a Japanese based company taking over?

    AFL has a good yield and an excellent history of dividend increases, but the question is will this continue?

    Thanks

  • Report this Comment On September 08, 2011, at 6:25 PM, TMFKopp wrote:

    @TheGMaster

    "Why is this and are there any competitive risks to the Japan market such as a Japanese based company taking over?"

    It's because the company has a long, strong history in Japan. It's been there for a long time and has claimed a very strong competitive position. As for risk, it certainly faces strong competition from Japanese companies and has the same risk of getting bumped aside as any industry leader anywhere. And some of the segments of its Japanese business have been worse than others.

    As far as comparing its U.S. business to its Japanese business, I think supplemental insurance is just more widely accepted in Japan. In the U.S. I think it may be a bit of a tougher sell since most people's knee-jerk reaction is "I already pay for health insurance, why do I need this?" Whereas in Japan it's more like "Ok, I know the government pays for X, so I need something to help me pay the rest."

    "AFL has a good yield and an excellent history of dividend increases, but the question is will this continue?"

    As of right now, I don't see why not. The company is committed to returning capital to shareholders, and it has a very low payout ratio, which gives it room to raise the payout even if earnings growth falters.

    Matt

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