Aflac Climbs the Wall of Worry

Aflac Inc (NYSE: AFL  ) , the supplemental insurance company sporting the famous duck mascot, has been battling "boogie men" for years. As soon as one is disposed, another takes its place.

While the stock has climbed up from the depths, I believe it remains significantly undervalued. Patient investors may ultimately reap a windfall.

The "Wall of Worry"
The epicenter of the 2008-09 financial crisis was the banking and insurance industries.  During the darkest days, serious questions were leveled as to whether financial corporations could remain solvent. Ultimately, the doomsday scenario was averted, and investors regained a level of renewed confidence in the industry.   

Aflac shares crashed from a 2008 peak of $65 to a low of about $17 a year later. A 2010 rebound stabilized the stock at about $50 a share. In retrospect, senior management navigated the crisis well. The company emerged from the crisis with earnings intact, and a good balance sheet. 

Next, the 2010-11 EU debt crisis spooked investors. Despite generating its sales in Japan and the United States, Aflac held EU securities; investors fretted that PIIGS governments would become insolvent and cause massive portfolio damage.  

Aflac management responded by methodically divesting itself of higher-risk EU securities.  Net investment income improved, along with earnings.

More recently, investors have been wringing their hands about Japanese currency. Some believe a weakening Yen will damage Aflac earnings and threaten the dividend, before finally cratering it because of unsustainable debt-to-GDP levels. The currency problems could, in extreme scenarios, lead to hyper-inflation and and government default. 

Aflac Japan comprises about three-quarters of total corporate sales. Notably, currency exchange rates is not a business risk, but an accounting issue. As a U.S. corporation, Aflac must convert financial results into one currency. In reality, the company exchanges very few yen for dollars. This Dividend Aristocrat (Aflac has raised the payout for more than 25 years in row) easily pays its entire annual cash dividend with cash generated by U.S. operations.

And what about near-term Japanese hyper-inflation and default? Well, I suppose anything is possible, but I think the probability of the third-largest global economy becoming insolvent is low. 

These worries have compressed the P/E ratio relentlessly. A year-end 2007 P/E of 18.7 tumbled to a decade low of 8.7 in December 2012. The current multiple has improved only marginally.

Valuation fundamentals
Three broad metrics with which to begin evaluation of insurance industry stocks include:

  •   price to earnings ratio
  •   price to book ratio
  •   PEG ratio

For side-by-side peer group comparison, let's looks at Travelers Company Inc (NYSE: TRV  ) and Prudential Financial Inc (NYSE: PRU  ) , since these international insurers are approximately the same size as measured by Enterprise Value. I have also included current dividend yield on the table below.

Source: Yahoo! Finance.

Preliminary results indicate that while Aflac is most attractively valued by trailing-12-month P/E, Travelers and Prudential trade at a lower price-to-book. Both peers have better five-year PEG ratios, too. However, all three companies are projected to grow EPS at similar rates in 2013 and 2014, somewhat mitigating the differential. I question analysts' ability to project EPS growth more than a couple of years out. 

It's often wise to dig a little deeper before drawing a conclusion. Taking the analysis another step, here are two historic charts highlighting net profit margin and return on equity. These metrics offer further insight into profitability and management effectiveness for these companies. 

 

Evidenced is the consistency by which Aflac has maintained and even improved margin and returns, while Travelers and Prudential have seen much less consistency. Indeed, these peers have experienced some long-term erosion in profit margin and return on equity over the past nine years.

Aflac management has appeared to most evenly handle all manner of business circumstances and obtain results over an extended period of time. A superior record of consecutive dividend raises and share repurchases simply add gloss to the ledger.

So what's Aflac stock worth?
I believe due to a litany of macro fears, Aflac stock trades at an unduly low P/E multiple.  Over the past 10 years, the market has assigned shares a normalized, P/E ratio of 15 times operating earnings. The current P/E is a 42% discount to that figure.

Assuming conservative 2013 estimate of $6 a share, and placing a 15 multiple on it, we arrive at a price of $90 per share.   

Such a valuation is further supported by a historical versus current price to book analysis. 

The current P/B is 2.11. The seven-year normalized ratio is 2.41; therefore, the current price/book isn't high by historic standards. Meanwhile, book value has been increasing by an average annual growth rate of 11% over the same period.

Estimating year-end 2013 book value at $38 a share, and multiplying by the historical 2.4 P/B average, yields $91 a share: a nearly identical price target versus the historic P/E multiple and EPS analysis.

Foolish bottom line
Aflac is a steady, well-managed, dividend payer. The business model remains sound.  Senior leadership has consistently steered the business through turbulent macro circumstances. 

Nonetheless, Mr. Market continues to worry about Aflac's future. The stock appears very undervalued as measured by historic P/E or P/B ratios. Analysis offers a target price of about $90 a share, or a or a 45 percent improvement from the recent closing quote. 

In addition, Aflac offers investors secure dividend growth. The 2.4% yield is safe; investors have enjoyed a raise in the payout for 30 consecutive years.

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