AFL AFLAC Inc

We reiterate our recommendation on Aflac Inc. (AFL) at Neutral, based on the current sustainability factor. The company’s first quarter operating earnings per share of $1.63 came in modestly higher than the Zacks Consensus Estimate of $1.52 and $1.41 reported in the year-ago quarter.

The growth in the first quarter was supported by higher premium income, modest investment yields, favorable dollar/yen exchange rate and improvement in the U.S. operations, which also drove operating ROE. However, higher claims and benefits due to the Japan catastrophe, lower-than-expected top line and higher investment losses partially negated the positives.

Nevertheless, Aflac’s strong brand name and solid business model enabled it to improve earnings considerably faster than other life and health insurers. Most significantly, the company is a prime insurer in Japan in terms of individual policies in force. Japan’s revenues accounted for 77% of the company’s total revenue in 2010, 73% in 2009, 72% in 2008 and 71% in 2007.

Aflac has been strengthening its Japanese operations consistently that also helped itself  survive the catastrophe losses better than its peers. Besides, Aflac continued to be the number one seller of cancer and medical insurance policies in Japan throughout 2010.

In the US, the strategic acquisition of CAIC in 2009 has added to Aflac’s product and distribution capabilities, which has started reflecting in the company’s results. CAIC contribution has been improving from 6% to 10.7% of the US sales production in 2010 and first quarter of 2011, respectively.

With superior financial strength ratings and a new group product platform, CAIC buyout is projected to be accretive to earnings in the long run. However, loss of a large payroll account, persistent lack of confidence from small businesses and fewer sales associates cast a cautious outlook on the sales opportunities in the U.S. in 2011.

Meanwhile, Aflac’s strong operating cash flow position (grew to $7.0 billion in 2010 from $6.2 billion in 2009, $5.0 billion in 2008 and $4.7 billion in 2007) further enhances the company’s scope for both inorganic and organic growth. Additionally, Aflac’s National Association of Insurance Commissioners (NAIC) risk-based capital ratio remained within 500% and 525% at the end of first quarter of 2011.

Going ahead, this strong capital and surplus position is expected to mitigate balance sheet risk and provide liquidity cushion to its long-term growth. Regular dividend increment and resumption of the stock buyback program further validate Aflac’s efficient capital deployment and fair liquidity. Meanwhile, Aflac also aims to get rid of its problem investments in Europe through the de-risking process, which is expected to last over the next 12–18 months.

Besides, Fitch Ratings upgraded its credit outlook on Aflac to stable from negative in April 2011, while A.M. Best affirmed its investment-grade debt ratings in May 2011, reflecting a stable outlook based on Aflac’s present financial leverage that is estimated to be around 23%, consistent with the rating category criterion.

However, Aflac continues to be harshly hit by intense economic volatility, the continued fluctuation of the yen against the dollar, changes in interest rates, changes in credit spreads and defaults, market liquidity and declines in equity price.

Although a slight improvement has been witnessed in the yen/dollar exchange rate during the last couple of quarters, we still remain cautious as the economic volatility will continue to weaken the targeted earnings growth till markets rebound to historical highs and provide buoyancy to exchange rates. Management further ascertained this apprehension with a conservative projection of a negative 2% to a positive 3% growth in Japan for 2011.

Despite the fact that Aflac is indulging in de-risking activities, it is moving towards less risky investments with lower yields, which will further lessen investment income. Moreover, the company’s substantial exposure to European financial institutions hybrid securities, below-investment-grade debt and perpetual securities is likely to result in statutory investment losses and lower reinvestment yields, thereby escalating the financial and capital risk.

Increased losses in the investment portfolio and lower income from the variable annuity business is expected to continue to hurt earnings at least in the near term, until the markets witness a steady recovery. Besides, the devastating earthquake and tsunami that hit Japan in March 2011 have raised catastrophe losses and weakened claims-paying ability.  This is also reflected in management’s estimation of earnings at the lower-end of the guidance.

Overall, weighing all the pros and cons, we believe a stable economy in the long run will gather momentum and negate interest and currency risk, thereby providing more profitable investment opportunities for Aflac.

 
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