Aflac: A Feathered Friend for Investors
We believe Aflac (AFL: $62) is well-positioned to benefit from the changing demographics and increasing health-care needs in the U.S. and Japan. We think the company's expansive distribution channels, solid business mix, operational efficiencies, and financial strength should enable it to continue its earnings and profitability momentum. The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).
We anticipate Aflac's Japanese unit, which accounts for the majority of the company's revenues and assets, will experience both top-line and margin growth in 2008. After declining for six quarters, sales in Japan grew in the third quarter of 2007, and we expect the turnaround to continue into 2008. We believe the claims issues that negatively affected 2006 and 2007 sales results are subsiding. We also anticipate deregulation of the bank channel in Japan will provide new opportunities for the company to sell its products.
Furthermore, the addition of Japan Post as a distribution partner bodes well for future sales and earnings growth, in our view. We anticipate the company's benefit ratio will improve as its business mix moves toward higher-margin products. Also, changes in Japan's hospital reimbursement policies are decreasing the average length of hospital stay and should improve the company's loss ratios.
In the U.S., Aflac focuses on voluntary insurance products marketed at the work site. The company has captured only 7% of the small business market (under 500 employees), and we believe it will be able to gain share in this market. Aflac has been investing in improving the number of average weekly producing associates and creating product awareness through its market efforts which should enable it to continue its double-digit sales growth, in our opinion.
We view Aflac's investment portfolio favorably. The investment portfolio is conservative relative to its peers and should be able to better withstand share-price volatility generated from a possible further deterioration in the credit market, in our estimation. Its investment portfolio does not have any subprime holdings and contains $42 million of Alt-A holdings, representing 0.1% of its invested assets. The company's mortgage-backed security (MBS), asset-backed security (ABS), and collateralized debt obligation (CDO) holdings represent 2.1% of invested assets. In addition, approximately 1.9% of the company's fixed-income securities are categorized as below investment grade, a percentage lower than its peer average of 5.3%, by our analysis.
Aflac provides supplemental health and life insurance in the U.S. and Japan. Most of Aflac's policies are individually underwritten and marketed at work sites through independent agents, with premiums paid by the employee. As of March, 2007, Aflac believed it was the world's leading underwriter of individually issued policies marketed at work sites.
Aflac Japan: For the first nine months of 2007, Aflac Japan accounted for 71% of total revenues, compared to 72% for the first nine months of 2006. Aflac Japan accounted for 82% of total company assets at Sept. 20, 2007, vs. 81% a year earlier. As of year-end 2006, Aflac Japan ranked first in terms of individual insurance policies in force, surpassing Nippon Life in March, 2003.
Aflac Japan's insurance products are designed to help pay costs not reimbursed under Japan's national health insurance system. Products include cancer life plans (34% of Aflac Japan's total sales for the first nine months of 2007, vs. 27% for the first nine months of 2006); Rider MAX (7.5% vs. 9.6%), a rider for cancer life policies that provides accident and medical/sickness benefits; and EVER (32% vs. 34%), a standalone whole life medical plan. Aflac Japan also offers ordinary life products (22% vs. 24%) and other products such as living benefit life plans and care products.
Under a marketing alliance established in 2001, Dai-ichi Mutual Life Insurance sold roughly 276,900 AFL cancer life policies in 2006, compared to 277,700 cancer life policies in 2005.
At the end of September, 2007, the number of licensed sales associates rose 14.5%, to approximately 101,171, compared to 88,376 on Sept. 20, 2006. The growth in licensed sales associates resulted primarily from individual agency recruitment.
Aflac Japan's main strategy for growth focuses on broadening its product line, diversifying its distribution system, and maintaining operational efficiency. To enhance its ability to broaden its product line, Aflac Japan has focused on shortening the development cycle to bring the products to market quickly. The company's distribution channels include affiliated corporate agencies, independent corporate agencies, individual agencies, and a marketing alliance with Dai-ichi Mutual Life. In our view, one of the company's greatest competitive strengths is its position as Japan's low-cost producer. We remain encouraged by Aflac Japan's expanding use of technology and new claims system and its commitment to operating efficiencies.
Aflac U.S.: Aflac U.S. sells cancer plans (16% of total Aflac U.S. sales for the first nine months of 2007, vs. 17% for the first nine months of 2006) and various types of health insurance, including accident and disability (52% vs. 52%), fixed-benefit dental (6.3% vs. 7.1%), and hospital indemnity (14% vs. 13%). Other products include long-term care, short-term disability, and ordinary life policies.
Aflac U.S.'s strategy is similar to that of Aflac Japan: Develop relevant products, improve and expand the distribution system, build brand awareness, and maintain operational efficiency. Aflac U.S.'s distribution system seeks to reach both employer and employee. As the company plans to expand its reach, we believe it is necessary for Aflac U.S. to continue to develop and expand its agent recruiting and training.
The Aflac duck has established a tremendous amount of brand recognition for Aflac, in our opinion, and we are encouraged by the company's decision to shift its advertising focus from brand recognition to brand definition. Aflac has continued to improve its operational efficiency through administrative infrastructure, new enrollment application, and IT initiatives.
In Japan, demographics, regulation, and increasing competition play crucial roles in the supplemental life and health insurance environment. Japan's aging population coupled with its declining birthrate presents a challenge to the benefits provided by the country's social security system and may lead the government to reform the benefits offered. We believe that a decrease in benefits provided would create demand for Aflac's supplementary products.
Deregulation of the bank channel in Japan is providing another catalyst for growth, in our view. Banks are now allowed to sell additional insurance products besides variable and fixed annuity products. To capitalize on this development, Aflac has developed relationships with many banks to sell its products. We anticipate these relationships will be a boon to sales.
The company faces increasing competition for its products in Japan. Other life insurance companies and financial institutions have been ramping up their supplemental life and health product offerings. However, the company has been able to maintain its market share, reflecting its distribution capabilities coupled with its operational efficiencies, which enable it to price competitively, by our analysis. Aflac Japan's market share of standalone cancer insurance business has remained stable, with a 79% share at the end of September, 2006.
In the U.S., we believe rising health-care costs and changing demographics provide opportunities for the company. According to the Kaiser Family Foundation's 2006 Employer Health Survey, employer-sponsored health insurance premiums increased by an average of 7.7% in 2006. Rising premium rates coupled with reduced coverage have resulted in employers seeking supplemental insurance products for their employees.
We see the company benefiting from demographic changes in the U.S. Aflac's marketing research has demonstrated that its products appeal to Hispanic consumers.
The growth in the Hispanic population in the U.S., along with the aging of the overall population, should provide selling opportunities for the company, by our analysis.
Over the past five years, the company's price-to-earnings ratio has ranged from 14 times to 20 times, while its price-to-book ratio (excluding the effects of accounting rule FAS 115) has ranged from 3.4 to 4.9 times. At recent price levels, Aflac shares are trading at 4 times book value (excluding FAS 115) and 16.2 times our 2008 operating earnings-per-share estimate of $3.82.
Our 12-month target price of $75 is based on a p-e multiple of 19.6 times our 2008 operating EPS estimate, above Aflac's industry peers. At our target price, the stock would trade at a premium to its peers based on both p-b and p-e multiples, which we believe is warranted, given what we see as Aflac's high quality of earnings, growth prospects, brand recognition, and capital flexibility.
We have a favorable view of the company's corporate governance practices. Positive factors, in our view: The board is controlled by a substantial majority (at least 50%) of independent outsiders; both the nominating and the compensation committees are composed solely of independent outside directors; the full board of directors is elected annually; and a board-approved CEO succession plan is in place. In addition, the company has neither a poison pill nor a dual class structure in place. Furthermore, all stock-based compensation plans have been approved by shareholders; executives and directors are subject to ownership guidelines; and the company's option plans do not expressly allow repricing.
On the negative side, we are concerned that the positions of the chairman and CEO are combined, the board has the authorization to change the size of the board without shareholder approval, and the board may amend the bylaws without shareholder approval.
Risks to our opinion and target price include unfavorable movements in the yen/dollar exchange rate; less organic premium growth than we expect, particularly on new product sales; distribution disruptions in Japan; a slowdown in the Japanese economy; higher-than-projected underwriting and marketing expenses; agent-recruiting difficulties; and lower-than-forecast share repurchases.