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Aflac: Buy This Undervalued, Accidently High Yielder

GuruFocus.com

- By Nathan Parsh

Whenever the market has a temper tantrum and decides to sell everything, it often throws out good stocks along with the bad. This can lead to a situation where the dividend yield is considerably higher than usual. This is what investors refer to as an accidently high yielder.

One excellent example of this is Aflac Inc. (NYSE:AFL). Shares of Aflac sold off along with the rest of the market in March as the Covid-19 pandemic spooked the market and resulted in dramatic selloffs in nearly every industry. Shares of Aflac have recovered somewhat from the lows, but the stock sits more than 30% off of the 52-week high.


While making a new 52-week high might not occur for sometime due to the uncertainty that remains in the market, Aflac's current yield is more than 50 basis points above its 10-year average.

This may not sound like much, but the share price would have to increase more than 20% in order for the stock to trade with its 10-year average dividend yield.

Shares of the company also trade below the long-term average. This could be a great opportunity for investors to acquire shares of an undervalued stock offering a higher than usual dividend yield.

Company background and quarterly highlights

Aflac has been in business since 1955. The company has grown to become the largest underwriter of supplemental insurance in the world. The company also sells cancer, accident, short-term disability, critical illness, life, dental and vision insurance. Aflac has operations in just two countries, Japan (70% of pretax earnings) and the U.S. (30% of pretax earnings). Aflac is valued at $27 billion today.

Aflac reported second-quarter earnings results on July 28. The company's revenue declined nearly 2% to $5.4 billion, missing Wall Street's consensus estimates by $80 million. However, the company did manage to produce a solid gain in profit. Adjusted earnings per share increased 15 cents, or 13.3%, to $1.28. This was 23 cents higher than expected.

The company did repurchase 5.2 million shares during the quarter, but Aflac's adjusted net earnings increased 8.9% to $921 million. This means that gains in earnings per share weren't exclusively due to share buybacks.

Currency is always going to be part of the equation with Aflac as the majority of sales are conducted in Japan, but results are reported in U.S. dollars. Currency exchange actually added a penny to adjusted earnings figures in the most recent quarter.

Net premium income for the Aflac Japan segment was flat at $3.2 billion. Total revenue grew 0.3% to $3.8 billion, while net investment income net of hedging costs grew 3.9% to $633 million.

The Covid-19 pandemic severely limited this segment's ability to conduct business. New annualized premium sales for protection-type products, which is the bulk of Aflac Japan's business, fell 60% in local currency. The pandemic limited contact between Aflac's employees and workers. The company also extended grace periods for premium payments in both Japan and the U.S. This quarter also faced a tough comparison in the second quarter of 2019, which saw strong sales related to Japan Post business.

Aflac U.S. net premium income was also flat at $1.5 billion. Total revenues improved 0.9% to $1.7 billion due to higher third-party administrative fees, but net investment income was lower by 4.4%. Aflac U.S. new sales were down almost 56% compared to the previous year, due primarily to the pandemic.

The company ended the second quarter with a remaining share repurchase authorization of 21.9 million shares. In addition, Aflac announced on Aug. 12 that it was going to add 100 million shares to its repurchase authorization. This total authorization represents 17% of the outstanding share count at the end of the quarter.

Aflac suffered high rates of decline in new sales as a result of the social distancing restrictions in both of its markets. However, net premiums were stable in both Japan and the U.S. This is a sign that Aflac's customers remained loyal to the company's products even in a difficult business environment. This should also provide some evidence that Aflac's products will remain in demand for new customers once the restrictions related to the pandemic have been eased. Aflac's leadership position in supplemental insurance should serve the company well following a recovery from Covid-19.

Insurance is often seen as a boring but steady business. Aflac has grown its earnings per share with a compound annual growth rate of 5.6% over the last decade. A solid, if not spectacular, growth rate. Even with Covid-19 headwinds, analysts who cover the stock expect the company to produce earnings of $4.65 per share this year. This would be a 4.7% increase from the previous year.

Dividend and valuation analysis

Companies that have steady business results tend to return capital to shareholders through dividends. Aflac is no different. The company raised its dividend 3.7% for the payment made this past March 2. As a result, Aflac now has 38 consecutive years of dividend growth.

The company has raised its dividend by an average of:

  • 9.2% per year over the past three years.

  • 7.9% per year over the past five years.

  • 6.8% per year over the past 10 years.



Aflac's dividend growth had been trending higher in the near term, though the most recent increase is down significantly.

On the plus side, the dividend is well covered using either earnings per share or free cash flow.

Investors should receive $1.92 of dividends per share in 2020. Using analysts' estimates for the year, the earnings payout ratio is just 41%. While this is a low payout ratio, it is much higher than the average payout ratio of 25% that Aflac has averaged since 2010. This might be the reason for the lower-than-usual increase as the company has typically had an extremely low payout ratio.

The free cash flow payout ratio is much better. Aflac distributed $193 million of dividends last quarter while generating free cash flow of $1.2 billion for a payout ratio of 16%. Year to date, dividends paid have totaled $388 million while free cash flow was $2.6 billion for a payout ratio of 15%. It is likely that this already extremely low payout ratio will only improve as the company embarks on an aggressive share buyback. Dividends distributed will be lower due to the lower share count.

Aflac has a share price of approximately $38 at the moment. Using the annualized dividend of $1.12, the stock has a dividend yield of 2.9%. The yield isn't as robust as when I bought the stock earlier this year, but it is higher than the 10-year average yield of 2.4%. For context, there is only two other times since 2004 that Aflac has averaged a higher yield for an entire year (2009 and 2012) according to Value Line. Shares would have to increase $9, or 24%, to $47 for Aflac to trade with its long-term average dividend yield.

The stock is also cheap compared to its historical average using the traditional price-earnings method for valuing securities. Using the current share price and expected earnings per share for 2020, Aflac has a forward price-earnings ratio of 8.2. The average multiple is 10.2 times earnings since 2010. Only once in the last 16 years has Aflac averaged a price-earnings ratio below 9. That was in 2009, when the multiple was 8.8 times earnings. Aflac is trading with one of its lowest valuations in a very long time. Applying expected earnings per share for the year by the average price-earnings ratio results in a price target of more than $47.

Final thoughts

Aflac definitely faced some headwinds during the second quarter, mostly as a result of the pandemic. Still, the company managed to maintain its net premiums and saw a strong gain on the bottom line. New sales were decimated, but overall sales dropped just slightly. This shows that Aflac has a product and service that consumers like once they have it. As social distancing restrictions ease, the company's new product sales should return to growth.

The company's most recent increase was very low, but its dividend is very safe in my opinion. The free cash flow payout ratio is in the mid-teens and is likely to decrease following a very large share repurchase.

Even after the stock has railed almost 65% off the March lows, the yield remains higher than normal. In addition, Aflac is undervalued compared to its decade-long average valuation. The stock still has 20%-plus returns to go before it trades with its long-term average yield and valuation. This makes shares of Aflac look like an excellent opportunity for investors.

Disclosure: the author has a long position in Aflac Inc.

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This article first appeared on GuruFocus.