Aflac (AFL): A Cheap Dividend Aristocrat or Value Trap?

Over the past decades boring old insurance specialist Aflac (AFL) has done a remarkable job of enriching long-term income growth investors thanks to its impressive 34-year dividend growth streak.

 

That’s courtesy of its strong, cash-rich business model, which has allowed it to grow its dividend by 14.6% annually over the past quarter century, resulting in annual total returns that easily beat the S&P 500’s.

 

Of course past performance is no guarantee of future results, and recently Aflac has struggled to generate the kind of sales, earnings, cash flow, and dividend growth that investors have come to expect from it.

 

However, many insurance companies can make for great investments. Warren Buffett would agree given his ownership of GEICO and some of the insurance investments in his dividend portfolio here.

 

Let’s take a closer look at this dividend aristocrat to see whether or not it deserves to be a part of a diversified dividend growth portfolio.

 

Business Overview

Founded in 1955 in Columbus, Georgia, Aflac (American Family Life Assurance Company) is the world’s largest supplemental health and life insurance provider serving over 50 million Japanese and US customers.  Its business is composed of two subsidiaries.

 

Aflac Japan (70% and 71% of 2016 annualized premiums and total revenue, respectively): cancer plans, general medical indemnity plans, medical/sickness riders, care plans, living benefit life plans, ordinary life insurance plans, and annuities.

 

Aflac US (30%, and 29% of 2016 annualized premiums, and total revenue respectively): accident, cancer, critical illness/care, hospital indemnity, fixed-benefit dental, and vision care plans; and loss-of-income products, such as life and short-term disability plans

 

Like most insurance companies, Aflac makes money in two ways. First, it attempts to use its long track record in these specialty industries to write profitable insurance policies that turn a profit.

 

And because it receives premiums up front, while only paying out claims on a percentage of its policies over the long-term, it has access to a large amount of what’s known as insurance “float,” meaning free cash which it can invest into a low risk portfolio of assets (i.e. bonds and stocks) which further generate income and profits.

 

 

Business Analysis

Aflac’s track record of strong dividend growth and market-beating total returns is thanks to its strong moat.

 

Aflac’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 over 60 years and in Japan for more than 40 years, building up significant brand equity.

 

In fact, management estimates that about 9 out of 10 people in Japan and the US recognize Aflac’s brand. The Aflac Duck was introduced in the early 2000s and has further benefited Aflac’s recognition.

 

While many insurance markets are fragmented, large players like Aflac have meaningful 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.

 

In addition to Aflac’s strong brand recognition and service, the company’s sheer size also plays to its advantage.

 

Aflac has built up a strong reputation and massive distribution networks over the course of many decades.

 

With such a large base of premium policies mostly being renewed each year, Aflac has the scale to keep its premiums very competitively priced (Aflac is the lowest cost provider in many cases) and offer compelling benefits to policyholders that smaller rivals cannot match.

 

It would take new competitors many years and cost a fortune to replicate Aflac’s distribution network, brand strength, and scale.

 

Beyond scale, channel networks, and brand recognition, Aflac’s actuarial expertise is another key advantage.

 

Specifically, its strong brand in specialized insurance products and skilled actuaries help it to avoid the kind of commoditization (i.e. low pricing power) that’s frequently the bane of many other insurance companies.

 

For more than a decade, Aflac’s annual cash flow from policy premiums has exceeded the policy benefits the company has paid out.

 

In other words, Aflac’s actuaries have done an excellent job assessing and pricing risk accordingly. This keeps Aflac’s costs very competitive and frees up more funds to be invested for additional income.

 

This can be seen in the Aflac’s long history of relatively low combined ratios, which represents the profitability of its insurance policies.

 

As you can see, Aflac’s combined ratio has been steady around 80% over time, indicating that it generates around a 20% operating profit margin on its policies.

 

 

To put that in context, non-specialized insurance companies generally have combined ratios of 95% to 105%, indicating very little operating profit or even a loss from their policies (due to high price competition and/or more aggressive policy writing).

 

These non-moat insurance peers essentially are trying to break even (or achieve razor thin profits) on policies and make up for it through net interest and capital gains from their investment portfolios.

 

Aflac’s highly profitable policies allow it to invests the excess premiums (i.e. float) into a very conservative (i.e. not likely to generate losses) portfolio of high-quality assets, mostly Japanese Treasury bonds and large international bank corporate bonds with very strong credit ratings.

 

 

This combination of highly profitable specialized policies, along with net investment gains from its float, has allowed Aflac to generate some of the insurance industry’s best margins and returns on shareholder capital.

 

 

Note that Aflac’s free cash flow (FCF) margin is especially impressive, indicating that the company is generating a strong river of cash which it has consistently returned to shareholders in the form of buybacks and growing dividends.

 

 

In fact, Aflac has a long history of steadily reducing its share count through buybacks.

 

 

The reason that buybacks can be such a friend to dividend investors is because by reducing the number of shares, a company’s dividend cost decreases, making it somewhat easier to grow dividends sustainably in the future.

 

And because Aflac’s sales growth has slowed in recent years (more on why in a second), the company has steadily increased its rate of buybacks:

• Over the past 12 years: 1.9% annual buyback rate
• Over the past 5 years: 4.1%
• 2017 guidance: 4.5%

This is because management, led by 44-year company veteran Daniel Amos, has decided to wisely stick to its circle of competence.

 

In other words, rather than try to restart its growth through ill-conceived acquisitions or expanding into new markets where it doesn’t know the culture and wouldn’t have a competitive advantage, Aflac is returning more cash to shareholders and in a way that maximizes its ability to keep growing the dividend for hopefully years and decades to come.

 

Key Risks

While there is a lot to like about Aflac’s disciplined business, there are also some major challenges the company will have to face.

 

First and foremost is that the company’s sales and earnings growth has been declining in recent years.

 

 

This is due to the company’s heavy concentration in Japan, a nation whose population is shrinking due to the world’s lowest birth rate. Japan has also experienced very weak economic growth since the bursting of the real estate and stock market bubbles in 1989 (which resulted in a severe distress for Japan’s overleveraged banks).

 

Or to put it another way, one of the things that has made Aflac so successful in Japan, people buying income insurance so that they will have enough to live on in their old age (without children to take care of them), is also the company’s achilles heel when it comes to growth because of a slowly shrinking customer pool over time.

 

Another problem for Aflac is that, while its profitability is among the best in the insurance industry, its margins and returns on capital have been declining in recent years.

 

This is largely because of lower returns on its investment portfolio, which is almost exclusively in low risk bonds and heavily concentrated in Japan.

 

Specifically, 44% of its investment portfolio is in Japanese Treasuries, which have some of the lowest interest rates in the world.

 

 

What’s worse is that the Bank of Japan’s (BOJ) recent attempts at economic stimulus, via printing money to buy Japanese bonds and ETFs, has resulted in yields on Japanese sovereign debt declining steadily over the years.

 

Japanese Asset Returns

 

In fact, the bank recently reiterated its resolve to buy as many bonds as it takes to keep 10-year Japanese yields at 0%. This means that going forward Aflac will either have to accept steadily declining net interest income from a large portion of its investment portfolio, or radically revamp its investment policy into higher-yielding US assets or equities, which carry greater risk.

 

US Asset Returns

Keep in mind that, while US fixed income (i.e. bond) yields have also been declining in recent years, rising US interest rates should help Aflac’s US investment portfolio generate stronger portfolio returns in the future.

 

In addition, in recent years the company has started more heavily investing in stocks, from just $19 million at the end of 2014 to $1.25 billion today.

 

That being said, the better potential for US bonds and higher long-term (but more volatile) equity returns ultimately won’t do much for Aflac’s bottom line as long as its lower performing Japanese assets continue to dominate its balance sheet.

 

Finally, there is one final major headwind to be aware of, which has also caused by Aflac’s excessive focus on Japan. This would be its high currency risk between the US Dollar and Japanese Yen.

 

 

As you can see, these currencies can swing wildly in relative price to each other, and when the Yen weakens it can hurt Aflac’s overall sales, earnings, and cash flow.

 

 

That makes sense since most of Aflac’s sales are denominated in Yen, which need to be converted to US Dollars for accounting purposes. Thus if the Yen weakens by 20%, it results in a 10% decrease in reported operating earnings and cash flow, despite the company’s currency hedging (without which the effects would be even worse).

 

The bad news for Aflac investors is that the Bank of Japan’s commitment to keeping that nation’s bond yields at record low levels could also be likely to weaken the Yen.

 

That’s because the funds used to buy those bonds are newly created (i.e. printed) money, which means that the BOJ’s attempts to stimulate its economy are devaluing the Yen and creating a long-term growth headwind for any US company operating in that country.

 

The Japanese government’s efforts to try and stimulate the economy could also have unintended consequences on Japan’s sovereign credit profile and create more volatility in Japanese capital and currency markets.

 

Finally, investors looking at the insurance industry should also note that insurance markets can go through cycles of increased pricing pressure and competition. However, Aflac is typically the lowest cost provider and has the financial strength and brand recognition to outlast almost all of its competitors.

 

Therefore, these occasional but inevitable bouts of cyclical weakness are likely buying opportunities rather than a reason to sell.

 

Aflac’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Aflac’s has a Dividend Safety Score of 97, indicating it has one of the safest and most dependable dividends on Wall Street, which is not surprising given that the company has been raising the payout steadily for 34 consecutive years.

 

 

This ability to maintain a highly secure and steadily rising dividend is courtesy of three main factors. The first being the highly predictable and recurring nature of the company’s cash flow created by monthly insurance premiums.

 

Second is that management has been very disciplined about maintaining low EPS and FCF payout ratios below 30%, ensuring a large safety cushion to the payout in the case of unexpected occurrences, such as extra large currency swings or an unusually high combined ratio one year.

 

 

Finally, Aflac has a very strong balance sheet, which means the company enjoys plenty of financial flexibility to potentially invest in future growth without having to sacrifice either dividend security or its steady payout growth.

 

For example, Aflac enjoys a very large cash position (enough to pay the dividend for almost six and a half years) and low net debt levels.

 

 

In addition, the company’s stream of free cash flow is large enough to fully pay off its debt within less than a year and provides a very high interest coverage ratio.

 

 

Combined with a lower than average debt/capital ratio (industry average is 25%), this explains why Aflac enjoys a strong investment-grade credit rating that allows the company plenty of access to low cost debt capital should it ever need it.

 

Aflac’s Dividend Growth

Our Dividend 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.

 

Aflac’s Dividend Growth Score of 75 seems to point to continued strong dividend growth in the future. However, keep in mind that this is mostly due to Aflac’s much faster growth rates in the past.

 

 

In recent years, the dividend growth rate has slowed considerably due to the company’s struggle to grow both its top and bottom lines.

 

Given the numerous headwinds Aflac is likely to face in the coming years, earnings seem likely to grow at more of a mid-single-digit pace, mostly due to continued share buybacks.

 

While the company’s very low FCF payout ratio can easily afford to grow to a higher level without sacrificing the security of the payout, Aflac shareholders probably shouldn’t expect more than 5% to 7% annual long-term dividend growth going forward.

 

Valuation

Over the past year Aflac has underperformed the S&P 500 by close 10%. However, while its valuations appear attractive on an absolute basis, today’s share price may not actually represent all that great a buying opportunity given the company’s low growth outlook.

 

For example, while the forward P/E ratio of 11.9 is much lower than the industry median of 14.9, as well as the S&P 500’s forward P/E of 17.6, it is actually slightly higher than Aflac’s 13-year median value of 11.3.

 

Meanwhile, AFL’s current dividend yield of 2.2% isn’t that much better than the S&P 500’s 1.9% and is actually below its historic norm of 2.4%.

 

In other words, though Aflac’s valuations are low on an absolute basis, the stock likely isn’t undervalued due to its slowing long-term growth prospects and the low interest rate environment around the world (especially in Japan).

 

In fact, investors buying Aflac today should probably only expect future annual total returns of 7.2% to 9.2% (2.2% yield + 5% to 7% dividend growth). While that isn’t a terrible return potential, it’s lower than the returns that many other quality dividend growth stocks are likely to generate.

 

Conclusion

While Aflac remains a dominant player in its highly profitable niche, and its steadily growing dividend makes it an appealing choice for low risk investors, at the end of the day the fundamental growth challenges in Japan are likely to result in slower payout growth than many investors may be expecting.

 

In other words, Aflac’s current yield isn’t high enough to make it an attractive candidate for most retirement portfolios. Investors seeking current income should review some of the best high dividend stocks here instead.

 

Meanwhile, Aflac’s future total return potential appears to be lower than other dividend aristocrats and dividend kings, many of which are likely to continue recording double-digit income growth and could be better choices for a diversified dividend growth portfolio.