Dividend investors should not neglect investing in insurance stocks.
Insurance companies enjoy a lucrative business model. Not only do insurers make money by collecting premiums, they also generate cash flow by investing the large sums of accumulated premiums that have not been paid out as claims, known as the float. This results in two income streams that lead to excellent profitability for many insurance companies. In return, certain insurers reward shareholders with rising dividends over time.
Aflac Inc. (AFL) is a profit-making machine. It currently pays a 2.3% dividend yield, and the company has increased its dividend for more than 30 years in a row. This qualifies Aflac to be a Dividend Aristocrat, an elite group of stocks in the S&P 500 with 25+ consecutive years of dividend growth.
Business Overview, Current Events and Growth Catalysts
Aflac's products include accident, short-term disability, critical illness, dental, vision, and life insurance. Approximately 70% of Aflac's premium income is derived from Japan, with the remaining 30% from the United States.
The company's main competitive advantage is its strong brand. The insurance industry is highly competitive, but Aflac's high brand recognition and advertising spending help to retain its brand image with consumers. The company invests significantly in advertising and marketing, and its Aflac duck mascot is widely recognized.
On Oct. 24, Aflac announced strong third-quarter earnings. Total revenue of $5.6 billion increased 1.3% from the same quarter a year ago. Total revenue increased 2.6% in the U.S., and 0.4% (in yen terms) in Japan last quarter. Premium income rose 2.4% in the U.S., but declined 0.9% (in yen terms) in Japan.
Overall, adjusted earnings per share of $1.03 increased by 21% year over year. Aflac's strong bottom-line performance was largely due to favorable pretax margins and a lower effective tax rate as a result of the U.S. federal tax reform.
The company's performance through the first nine months of the year was similarly strong. Total revenue increased by 2.4%, while adjusted diluted earnings-per-share grew by 21% over the first three quarters.
Insure Your Portfolio With Rising Dividend Income
Aflac has a long history of steadily growing its dividend, increasing the payout to shareholders for 35 consecutive years, which places it on the exclusive list of Dividend Aristocrats. As mentioned earlier, this long history of dividend growth is the result of its strong brand, and highly profitable business model. Aflac should enjoy steadily-rising premium income over time, as insurance is a product that will always see a certain level of demand.
Aflac is also investing in new products to generate growth, such as "third-sector" insurance that is increasingly popular in its major market of Japan. Third-sector products include non-traditional offerings such as cancer insurance. Aflac expects 2% to 3% growth in third-sector products in Japan this year.
Aflac's earnings growth will also see a boost from rising interest rates. While many companies that issue debt will be negatively impacted by higher interest rates, banks and insurance companies are among the beneficiaries during a rising-rate cycle. With interest rates moving higher over the course of 2018, Aflac's net investment income rose 8.3% in Japan and 3.3% in the U.S. in the third quarter.
Higher rates will be a continued tailwind for Aflac, as the company has a huge level of cash and investments on its balance sheet -- $124.2 billion of cash and investments as of September 30, to be exact. Higher interest rates will allow Aflac to earn higher income from its fixed income investments. Meanwhile, Aflac's float is a competitive advantage, as it is non-callable debt with no (or actually negative) interest expense so long as the company is able to operate at a breakeven level of insurance underwriting.
From an income perspective, Aflac's payout ratio rarely exceeds 30% going back several years. This allows the company to raise its dividend each year, while leaving plenty of profits to reinvest in advertising and growing the business. As a result, investors should expect many additional years of dividend growth from this blue-chip insurance conglomerate.
Expected Shareholder Returns
Aflac stock could generate double-digit annual returns going forward, comprised of dividends, earnings growth and capital appreciation.
In terms of valuation, the stock currently trades at a price-to-earnings multiple of 11x, using 2018 earnings estimates of $4.05 per share. This is slightly below fair value, which is estimated to be a price-to-earnings multiple of 12x. As a result, Aflac stock appears to be undervalued, which means an expanding stock valuation could add 1.6% to Aflac's annual returns over the next five years if mean reversion were to occur.
In addition, Aflac stock has a 2.3% current dividend yield, and the company is expected to generate 8% annual earnings growth. The combination of valuation changes, dividends, and earnings growth results in potential total returns of nearly 12% per year for Aflac stock over the next five years. This is a high rate of return and makes Aflac stock attractive for both value investors and dividend growth investors.
(This article was originally sent Nov. 20 to subscribers of TheStreet's Income Seeker, a product presenting the world of opportunities in fixed income and dividend stocks. Click here to learn more about Income Seeker and to receive articles like this each day from Nick McCullum, Peter Tchir, Chris Versace and others.)
