Aflac (AFL): the duck’s got game

Aflac (AFL) is currently one of my favorite undervalued dividend stocks. I’ve mentioned it briefly in two prior posts (here and here). The company’s core business is strong and has great growth prospects. The current market environment has it quite undervalued and thus presents a great opportunity for patient long term investors. In this post I’ll describe why I think AFL is such a good investment.

AFL is an insurance company at its core. It provides a unique type of insurance, supplemental health insurance, which gives it a heads up on competition. The first thing that matters for an insurance company from an investor’s perspective is does the company make money on its core insurance business, called an underwriting profit. Here AFL excels. Even during the last five years, through the financial crisis, the company has maintained a combined ratio of about 80% on average. That means it earns $0.20 on the dollar just doing its core business. This has led to industry leading ROEs in the mid 20s. Despite this strength the company trades at a historically low valuation. Lets turn to that next.

For a detailed look at AFL’s valuation take a look at this recent article (here). I’m going to focus on a simpler higher level approach. The 10 year chart below shows AFL’s stock price, P/E ratio, P/B value, and dividend yield.

Based on P/E, dividend yield, or P/B AFL is trading at a very low valuation relative to its past. This is a company that has increased its dividend for 29 consecutive years, is a member of the dividend champions, and has shown remarkable resilience even during the financial crisis. So, what gives? The big red flag to look for in such a situation is if the stock is a value trap. In other words it may be cheap for a very good reason. I discussed value traps in a previous post. The way you look for value traps is to see if there is any deterioration in the company’s core business. Doing this for AFL shows no such deterioration (see here). Looking at the growth rates in revenue, operating income, net income, and earnings per share for example shows 3 yr growth rates higher than the 10 yr growth rates. For example, revenue growth over the last 3 years has averaged 10.23% as compare to its 10 yr growth rate of 8.73%. The reason AFL is trading at a low valuation then is not due to weakness in its core business. It is primarily due to fears of impacts to its investment portfolio from the European crisis.

Are the fears of a potential huge impact to AFL’s investment portfolio from the European crisis justified? Well, not really. The European crisis has certainly impacted AFL’s investment portfolio but AFL management has taken active steps to reduce this risk. In the last 3.25 years, AFL has de-risked its European investment portfolio to the tune of $12.7B. Europe is down to 27% of their investment portfolio and more importantly their exposure to the PIIGs is down to only 10% of book value as shown below. In other words, while there could be further impact from Europe, this issue is largely behind AFL and is being drastically discounted in AFL’s share price by the market.

As far as potential future returns lets turn to the dividend return formula, or what I have termed the magic dividend formula. With AFL priced at a  dividend yield of 3% and assuming a conservative forward dividend growth rate of 10%, I think a conservative estimate on future returns are 13% (3% plus 10%) per year with no change in valuation. Respectable compared to other options but the potential upside is what makes this situation especially attractive. Just a return to a market multiple would imply an upside in AFL of 50% and a return to AFL’s historical valuations would imply a return of 100% or more. As far as downside, in another European upheaval shares could trade down to similar valuations last seen in Sept 2011 which would imply a price of approximately $38 or about 15% below today’s levels. This is a good risk/reward setup. I would advise building a position over time and taking advantage of pullbacks. The chart below shows the recent price action in AFL shares.

In summary, AFL is a great business with great prospects trading at a historically low valuation for no good reason. The market is over estimating the impact of the European mess on AFL’s long term value. AFL offers compelling returns with no change in valuation, significant upside with a return to a market multiple, and limited and manageable downside.