Updated January 15th, 2019 by Bob Ciura
Insurance is a great business. Not only do insurers collect revenue from policy premiums, they also make money by investing the 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.
High profitability allows many insurance companies to pay dividends to shareholders, and raise their dividends over time. For example, Aflac (AFL), has increased its dividend for 35 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 in the U.S. and Japan, with Japan accounting for approximately 70% of the company’s premium income. 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.
Aflac’s strategy is to increase premium growth through new customers, as well as increase sales to existing customers. It is also investing to expand its distribution channels, including its digital footprint, in the U.S. and Japan.
Source: Investor Presentation, page 4
Aflac continues to perform well overall. The company announced solid quarterly results for the most recent quarter. Total revenue of $5.6 billion increased 1.8% from the same quarter last year. Revenue increased 2.6% in the U.S., partially offset by a 0.4% decline in Japan. Aflac’s adjusted earnings-per-share of $1.03 increased 21% year-over-year. Earnings growth was attributable to the company’s revenue growth, margin expansion, as well as a boost from tax reform.
The company also posted strong results over the first three quarters of 2018, with 2.4% revenue growth and 21% earnings growth over the nine-month period.
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. Aflac expects to increase its U.S. sales by 3% to 5% in 2019.
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. Growth in these products is expected to continue, although Aflac expects overall sales in Japan to decline slightly in 2019.
Source: Investor Presentation, page 10
Aflac has enjoyed strong demand in Japan for third-sector products, due to the country’s aging population, and declining birthrate. 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. With interest rates on the rise over the course of 2018, Aflac’s net investment income increased 8% in Japan and 3% in the U.S. in the third quarter. Aflac ended last quarter with $124 billion in cash and investments on the balance sheet. As a result, higher interest rates could be a significant tailwind for the company’s profits.
Overall, investors can reasonably expect Aflac to grow earnings-per-share by 8% annually over the next five years.
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.
Aflac’s strong brand is a key competitive advantage. Competition is intense in the insurance industry. Insurance companies are constantly trying to lure each others’ customers. To retain customers and attract new customers, Aflac invests heavily in advertising.
Aflac is also a recession-resistant company. It 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, its earnings-per-share came roaring back in 2009 and 2010.
Valuation & Expected Returns
Aflac shares appear to be undervalued today. Based on 2018 expected earnings-per-share of $4.05, the stock trades for a price-to-earnings ratio of 11.2. The current valuation is below our fair value estimate, which is a price-to-earnings ratio of 12.0.
The slight undervaluation of the stock is expected to be a modest boost to annual shareholder returns. If Aflac’s price-to-earnings multiple expands to 12 over the next five years, shareholder returns would increase by 1.4% per year.
In addition, Aflac shareholders will generate returns from the company’s earnings growth, which we expect to reach 8% annually. Lastly, Aflac’s dividend will contribute to shareholder returns. The company has a current annual dividend payout of $1.04 per share, which represents a 2.3% dividend yield.
Importantly, Aflac’s dividend is very safe. We analyze the firm’s dividend safety in the following video:
Overall, the combination of valuation changes, earnings growth, and dividends is expected to result in total returns of 11.7% per year for Aflac stock. This is an attractive rate of return, from a highly profitable Dividend Aristocrat.
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.