Published October 10th, 2017, by Bob Ciura
Insurance is a highly profitable business model.
Not only do insurers collect revenue from policy premiums, they also make money by investing the massive sums of accumulated premiums not paid out in claims, known as the float.
Even legendary investor Warren Buffet sees the value of insurance stocks–his investment conglomerate Berkshire Hathaway (BRK.A) owns GEICO.
Possessing two revenue streams, along with low capital expenditure requirements, allows insurance companies to pay dividends to shareholders, and raise their dividends over time.
For example, another high-quality insurer, Aflac (AFL), has increased its dividend for 34 years in a row.
Aflac is a Dividend Aristocrat, a group of companies in the S&P 500 Index, with 25+ consecutive years of dividend increases.
This article will take an inside look at Aflac’s business model, and what drives its impressive dividend growth.
Aflac was formed in 1955, when three brothers—John, Paul, and Bill Amos—came up with the idea to sell insurance products that paid cash if a policyholder got sick or injured.
In the mid-twentieth century, workplace injuries were common, with no insurance product at the time to cover this risk.
Today, Aflac has a wide range of product offerings, some of which include accident, short-term disability, critical illness, hospital indemnity, dental, vision, and life.
The company specializes in supplemental insurance, which pays out to policy holders if they are sick or injured, and cannot work.
Aflac operates two insurance segments:
- Aflac Japan (70% of premium income)
- Aflac U.S. (30% of premium income)
Investors might be surprised to know that the majority of Aflac’s premium income comes from Japan. Because of this, investors are exposed to currency risk. Aflac’s earnings will fluctuate, in part based on exchange rates between the Japanese yen and the U.S. dollar.
When the yen rises against the dollar, it helps Aflac because each yen earned becomes more valuable when it is reported in U.S. dollars.
Source: June 2017 Investor Presentation, page 3
Still, the core business continues to perform well. Aflac’s operating earnings-per-share increased 5% in 2016, to $6.79. Revenue increased 8% for the year, to $22.6 billion.
2017 is off to a good start as well. Operating earnings-per-share increased 5.7% in the first half of the year. In the first six months, total revenue and premium income both increased 2%
Aflac has positive growth prospects moving forward, because it is developing new products to generate growth.
For example, in the U.S., Aflac is expanding its two-channel distribution model to bring in additional customers. Over the long-term, Aflac maintains an outlook of 3%-5% annual growth in the U.S.
In the company’s core market, Japan, Aflac is expanding its offerings of “third-sector” products. These include non-traditional products such as cancer insurance, as well as medical and income support.
Source: June 2017 Investor Presentation, page 4
Aflac has enjoyed strong demand in Japan for third-sector products, most likely due to the country’s aging population, and declining birthrate.
Third-sector sales increased 6.6% over the first half of 2017. Moving forward, Aflac expects 4%-6% annual growth in third-sector product sales in Japan.
Another growth catalyst for Aflac is rising interest rates.
As previously mentioned, Aflac makes money in part by investing its accumulated premiums. Aflac earned $703 million in investment income in 2016, a 4% increase from the previous year.
Higher interest rates could boost Aflac’s earnings growth, by increasing its investment income.
This is likely to be a significant impact, since Aflac ended last quarter with $121.9 billion in total cash and investments, up 1% from the previous quarter.
For 2017, Aflac management expects diluted earnings-per-share of $6.40 to $6.65. At the midpoint of guidance, this would represent 2% growth from 2016.
Competitive Advantages & Recession Performance
Aflac has many competitive advantages. First, it dominates its niche. It operates in supplemental insurance products, and is the leading company in that category.
The company also has a strong brand, its business model has low capital expenditure requirements, and it sells a product that enjoys steady demand.
These competitive advantages help Aflac remain highly profitable, year in and year out. Aflac remained profitable even during the Great Recession:
- 2007 earnings-per-share of $3.27
- 2008 earnings-per-share of $2.62 (20% decline)
- 2009 earnings-per-share of $3.91 (49% increase)
- 2010 earnings-per-share of $5.13 (31% increase)
Aflac had a tough year in 2008, which is understandable given the deep recession at the time. However, the company came roaring back in 2009 and 2010.
Valuation & Expected Returns
On a valuation basis, Aflac appears to be undervalued. In the past four quarters, Aflac reported operating earnings-per-share of $6.86.
As a result, Aflac has a trailing price-to-earnings ratio of 12. This is a fairly low valuation; the S&P 500 Index has an average price-to-earnings ratio of 25.4.
This means that Aflac is valued at less than half the valuation of the S&P 500. Aflac stock could generate significant returns going forward, just from an expanding valuation multiple.
For example, if Aflac stock held a price-to-earnings ratio of just 16—still a modest valuation—the stock would return 33% just from multiple expansion.
Plus, Aflac can provide returns from earnings growth and dividends. Aflac has positive earnings growth, and uses a significant portion of cash flow to reward shareholders with cash returns.
Source: June 2017 Investor Presentation, page 9
Over the long-term, a potential forecast of total returns is below:
- 3%-5% operating earnings growth
- 2% share repurchases
- 1% margin expansion
- 2% dividend yield
Based on this projection, Aflac could conservatively generate approximately 8%-10% annual returns, not including returns generated by an expanding price-to-earnings multiple.
Aflac is a high-quality company, with a profitable business and durable competitive advantages. The company has increased its dividend for over 30 years in a row, and should continue to do so, thanks to a low payout ratio and earnings growth.
While Aflac does not have the highest yield around, it offers steady dividend increases and a reasonable valuation. As a result, it is still an attractive stock for dividend growth and value investors.