Aflac (AFL) is a well-known insurance company that has proven to be a very reliable dividend payer over the years. The company has increased its dividend for 33 consecutive years and has plenty of room for continued dividend growth.
The insurance business has many attractive characteristics, but AFL’s high exposure to Japan has served as a meaningful headwind over the past few years. The stock currently trades at less than 10x forward earnings, and we hold the stock in our Top 20 Dividend Stocks portfolio.
Business Overview
AFL is the number one provider of individual voluntary insurance products at the worksite in the U.S. and protects one in four households in Japan. AFL provides insurance to more than 50 million people worldwide and was founded in 1955.
AFL’s insurance operations generate cash in two ways – policy premiums and investment income. Policy premiums are the company’s primary source of cash flow and are generated from policy renewals and new policies issued.
In Japan, AFL’s key product lines are life insurance and supplemental insurance products such as cancer and medical insurance. In the U.S., AFL’s product line includes income-loss protection (e.g. disability, life), supplemental medical (e.g. dental, vision), and asset-loss protection (e.g. accident, cancer, critical illness). AFL pays cash benefits to policyholders when they get sick or hurt, helping them replace lost income from missed work and asset losses.
AFL also invests its premiums to earn additional income and offer policyholders more competitive premiums and benefits. Investments are matched with AFL’s policy liabilities by both duration and currency.
By geography, AFL generated 72% of its revenue in Japan during 2014. The rest of AFL’s business is in the U.S.
Business Analysis
AFL’s primary competitive advantages are derived from the company’s brand recognition, leading market share, distribution channels, financial strength, and conservative approach to risk management.
The company has operated in the U.S. for 60 years and in Japan for 40 years, building up significant brand equity. Management estimates that about 9 out of 10 people in Japan and the U.S. recognize AFL’s brand. The Aflac Duck was introduced in the U.S. and Japan in 2000 and 2003, respectively, and has further benefited AFL’s recognition.
AFL’s business actions over the years have also positioned the company favorably with consumers. For example, the company introduced its One Day Pay claims initiative in the U.S. in February 2015. One Day Pay focuses on the speed of claims payments and means that AFL processes, approves, and pays a claim in just one day, helping lift policyholders’ financial burden quickly.
Getting cash in the hands of policyholders faster than anyone else is very important because they are experiencing a very difficult time of their life. AFL expects to reach over 2 million people with One Day Pay in 2015 and believes that 70% of its policyholders can use One Day Pay for their claims. Actions like these further build up AFL’s brand reputation.
While many insurance markets are fragmented, large players like AFL have meaningfully advantages over their smaller counterparts. Since insurance products are very similar in nature from one supplier to the next, competitors must try to differentiate on quality of service, brand recognition, and financial strength. We already touched on AFL’s strong brand recognition and service, but the company’s sheer size also plays to its advantage.
AFL has built up a strong reputation and massive distribution networks over many decades. With such a large base of premium policies mostly being renewed each year, AFL has the scale to keep its premiums very competitively priced (AFL is the lowest cost provider in many instances) and offer compelling benefits to policyholders that smaller rivals cannot match.
Beyond scale, channel networks, and brand recognition, AFL’s actuarial expertise is another key advantage. For at least the last 10 years, AFL’s annual cash flow from policy premiums has exceeded the policy benefits the company has paid out. In other words, AFL’s actuaries have done an excellent job assessing and pricing risk accordingly. This keeps AFL’s costs very competitive and frees up more funds to be invested for additional income.
It would take new competitors many years and cost a fortune to replicate AFL’s distribution network, brand strength, and actuarial expertise.
Key Risks
While AFL has plenty of staying power, the business faces several challenges. Like all other insurance businesses, AFL runs the risk of mispricing its policies or facing a “black swan” event that forces it to pay out more policy benefits than expected. There’s nothing we can really do about this other than look at management’s track record, which has been excellent (policy premiums have exceeded benefit payouts for at least the last 10 years).
Insurance markets can also go through cycles of increased pricing pressure and competition. However, AFL is typically the lowest cost provider and has the financial strength and brand recognition to outlast almost all of its competitors. With a favorite holding period of “forever,” we are less concerned with this risk impacting AFL’s long-term earnings potential.
The bigger issue with AFL is Japan, where the company generated over 70% of its sales last year. The Japanese yen has declined by 30% since 2012, causing fewer dollars to be reported on AFL’s financial statements.
Furthermore, about 39% of AFL’s total portfolio of debt and perpetual securities was invested in Japanese Government Bonds (JGBs) as of 12/31/14. JGBs have extremely low interest rates and have significantly limited AFL’s investment income, which is expected to decline by 1-2% in Japan in 2016.
Since 2012, AFL has been working to improve the return and risk profile of its Japanese investment portfolio. The company also hired a new Chief Investment Officer of Aflac Japan, which will hopefully help the portfolio’s long-term returns as it attempts to move into investments outside of JGBs.
Japan’s economy faces several challenges that could cause foreign exchange and interest rate headwinds to persist. The country’s economy recently dipped into a technical recession, its population is aging, birth rates are declining, and medical treatment costs are increasing. The Japanese government is undertaking actions to try and stimulate the economy, which could have unintended consequences on Japan’s sovereign credit profile and create more volatility in Japanese capital and currency markets.
S&P and Fitch actually cut their credit ratings of Japan by one level earlier this year, citing little chance of the government’s strategy turning around the poor outlook for economic growth and inflation over the next few years.
It’s challenging to forecast how these factors could impact AFL’s earnings from Japan, but we believe AFL’s conservatism and the stock’s depressed multiple help mitigate this risk. The company will also continue seeking organic growth opportunities via channel network expansion, potential new products, and maybe even new geographies one day.
Dividend Analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. AFL’s long-term dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
AFL earned a very strong dividend Safety Score of 99, suggesting its dividend payment is very secure. The company maintains a low payout ratio, generates consistent free cash flow, is conservatively managed, and has a healthy balance sheet.
Over the last four quarters, AFL’s earnings payout ratio is 28%, providing plenty of cushion and room for future dividend growth.
Looking below, we can see that AFL’s payout ratios have remained at conservative levels over the last decade, indicating that the company’s dividend growth has been driven by solid earnings growth.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
We also like to see how companies performed during the financial crisis to gauge their sensitivity to the broader economy. AFL’s reported sales and free cash flow per share actually grew each year, and the stock outperformed the S&P 500 by about 12% during 2008. This highlights the conservative nature of AFL’s insurance and investment portfolios and the non-discretionary nature of many of its products.
Source: Simply Safe Dividends
AFL has also maintained a high and stable return on equity over the last 10 years. As seen below, AFL’s return on equity has averaged close to 20%. AFL’s ability to invest policyholders’ premiums helps it generate high returns without needing to commit much of its own capital.
Source: Simply Safe Dividends
AFL’s capital-light business model makes it a very consistent free cash flow generator as well. We can see that the company has generated positive free cash flow in each of the last 10 years. Free cash flow generation is very important because it allows a company to comfortably reinvest and return capital to shareholders without the assistance of capital markets.
Source: Simply Safe Dividends
AFL’s balance sheet also looks to be in decent shape. The company’s long-term debt to capital ratio is a modest 0.23, and the company generated more free cash flow ($6.6 billion) last fiscal year than its total book debt balance ($5 billion). Moody’s (Aa3) and S&P (AA-) have also assigned strong credit ratings to AFL.
Finally, it’s worth mentioning that AFL’s annual policy premiums have more than covered 100% of the company’s total claims for at least the last 10 years, highlighting the conservative approach AFL takes to managing its business. While insurance companies carry murkier liabilities than average firms, this data point gives us greater comfort in AFL’s operations.
Altogether, AFL’s dividend looks very safe to us.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
AFL’s dividend Growth Score was a strong 78, which means that the company has significant flexibility to grow its dividend going forward. While the business faces near-term exchange rate headwinds and operates in mature markets, the company’s low payout ratio (28%), consistent free cash flow generation, and healthy balance sheet support long-term dividend growth.
AFL has increased its dividend for 33 consecutive years and most recently raised its dividend by 5% in November 2015. The stock is one of 51 dividend aristocrats and appears to have plenty of flexibility to continue growing its dividend at a mid-single digit growth rate each year (management’s goal is to grow the dividend at a rate in line with the increase in operating earnings, excluding foreign currency impacts).
As seen below, AFL’s dividend has increased at a 5-6% annual rate in recent years.
Source: Simply Safe Dividends
Valuation
AFL trades at 9.7x forward earnings and offers a dividend yield of 2.7%, which is above its five year average dividend yield of 2.4%. AFL’s dividend yield is likely too low for investors living off dividends in retirement, but its dividend growth is reliable and the stock’s total return potential is more interesting.
We believe AFL’s earnings can grow at least 3-6% per year over the longer-term, suggesting that the stock offers total annual return potential of 6-9% per year. The stock’s earnings multiple could also increase considerably and further boost total returns if Japan’s economy starts to improve and interest rates edge up. However, for the next year or so, these headwinds seem likely to persist.
Conclusion
Despite headwinds in Japan, AFL seems likely to remain a blue chip dividend stock for years to come. The company has strong brand recognition, benefits from economies of scale (low cost provider), and is very healthy financially. Today’s valuation appears to be undemanding, although it is impossible to predict when macro conditions in Japan will stabilize and begin showing signs of improvement. Until then, we expect AFL to continue improving the risk profile of its investments and work on numerous growth initiatives to position its business well for the long term. For long-term dividend growth and consistency, AFL looks like a reasonable bet to us.
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