Beating Buffett

Aflac’s Outlook Is Just Ducky
By JACQUELINE DOHERTY- Barrons July 24, 2010

Wall Street’s concerns about Aflac’s investment portfolio have depressed the insurer’s stock-market valuation and obscured its powerful earnings growth.

THE AFLAC DUCK enjoys enormous popularity. Too bad the same can’t be said for the insurance company it represents.

Columbus, Ga.-based Aflac (ticker: AFL) long was admired by investors for the rich returns it generated, especially in Japan, where it has built a lucrative business selling supplemental cancer policies. The global financial crisis dealt the company’s shares a major blow, however, sending them to 13 in last year’s first quarter, from a prior high of 67.

Aflac’s mascot is far more beloved than the company’s shares. Their upside potential is something to quack about.
These days the stock trades around 50, even as investors grapple with fresh concerns about the company’s investments in the debt and other securities of European banks. Some of those banks are in Portugal, Italy, Greece and Spain, and could face troubles of their own as these countries struggle to pay their debts.

Bullish analysts and investors believe the market’s fears have gone too far. “The market is overpricing the risk in the [investment] portfolio,” says James Tarkenton, a portfolio manager at Lateef Investment Management, which owns Aflac shares.

Aflac has $9 billion of shareholder equity, $1.5 billion of excess regulatory capital, and sufficient cash flow to absorb future writeoffs. The company is exposed to Germany’s Hypo Real Estate, one of seven banks that European regulators said Friday would have to raise capital to weather a future crisis. But Aflac’s position—holding $245 million debt issued by Hypo Real Estate—represents just 0.34% of the insurer’s $73 billion investment portfolio.

Aflac’s earnings should be more than enough to cover any losses, says President and CFO Kriss Cloninger, who told Barron’s he “doesn’t foresee the need to raise equity.”

Nigel Dally, an analyst at Morgan Stanley, says the company could absorb about $2.5 billion to $3 billion of pretax losses, although “that is well above any number we’d reasonably expect.”

With Wall Street focused on the company’s investment portfolio, little attention has been paid to estimates of 8% to 12% growth in 2011 in Aflac’s operating earnings, excluding currency translation. Shares trade for only eight times 2011 projected profits, when a multiple of 12 times earnings is more appropriate, says Scott Chapman, another Lateef manager. Based on the 2011 consensus earnings estimate of $5.96 a share, that multiple would result in a stock price of 71.

Aflac will report second-quarter earnings Tuesday. Analysts have penciled in $1.33 a share for the period, and $2.6 billion, or $5.45 a share, for the full year, on revenue of $20.4 billion. The company garners 73% of its premiums, and 78% of operating profit, from sales of supplemental policies in Japan; the remainder is generated in the U.S. Aflac is a market leader in Japan, but has had a tougher time domestically, particularly in recent years, as high unemployment has reduced the ranks of those who purchase policies through employers.

Like all insurers, Aflac invests the money it collects from policyholders, and tries to generate more income from its investments than it will have to pay out in claims. Despite today’s low interest rates, the company has been able to turn a profit on its investment portfolio.

Aflac at a Glance
Aflac’s financial holdings may be a lot safer than some skeptics fear. Shares, which have been volatile in the past three years, yield 2.2%.

Recent Price 49.85
52-Week High 56.56
52-Week Low 31.71
Revenue ‘10E (bil) $20.4
Free Cash Flow ‘10E (bil) $1
EPS ‘10 E $5.45
P/E ‘10 E 9.1
EPS ‘11 E $5.96
P/E ‘11 E 8.4
Sharehldr. Equity (bil)* $9
Total Portfolio (bil)* $73
Invest. in Financials * $26.4
Dividend Yield 2.2%

E=Estimate. *As of 3/31/10
Source: Thomson Reuters; Company reports
Aflac has about 87% of its portfolio in traditional bonds, 10% in perpetual securities that don’t mature, and under 1% in stocks. The company does its own credit research, and has sought to invest in the top-ranked financial institutions in many countries, in the belief, says Cloninger, that it would be in each country’s “interest to ensure those institutions weren’t going to fail.”

Mistakes have been made. Aflac incurred a $140 million after-tax loss on an investment in Lehman Brothers in 2008, and a $117 million after-tax loss on its investment in Icelandic banks. Second-quarter results will include a $67 million loss on the sale of $270 million of Greek debt.

BUT SKEPTICS WOULD DO WELL to focus on the portfolio’s three major strengths: It is well diversified by position; It is invested mostly in long-term debt, much of which has rallied as interest rates have fallen and credit markets have improved, and it has little liquidity risk. Unlike life insurance policies, the majority of Aflac’s policies can’t be surrendered to the company at any time for cash. Thus, Aflac can hold investments until they mature.

The Bottom Line
At a recent 50 a share, Aflac trades for eight times 2011 earnings estimates. One investor argues they’re worth 12 times earnings, which implies a price of 71.
“Time is on our side,” says Cloninger. “We’re generally able to be patient and not react to the crisis of the moment.”

About a third of Aflac’s portfolio is in “held to maturity” assets; the remainder are considered “available for sale” and are marked to market every quarter. About two-thirds of the company’s investments are in potentially less-liquid privately placed securities.

As investors gain more confidence in Aflac’s investment portfolio, they are likely to refocus on its earnings power. They are apt to find the insurer’s prospects a lot more impressive than they’ve been quacked up to be.

Larry,

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Paul