SAEF - Aflac Has Potential For Further Gains

• Aflac reported Q2 results on August 1st, beating EPS expectations by 20%.
• Over the past 4 years, EPS has exceeded expectations in every quarter.
• Rising interest rates tend to be favorable for AFL.
• The Wall Street consensus rating is neutral and indicates AFL shares are slightly overpriced.
• The market-implied outlook (calculated from options prices) continues to be bullish.

Aflac Incorporated (AFL) has substantially outperformed the broader U.S. equity market and the life insurance industry over the past year. AFL’s total return over the past 12 months is 13.9%, as compared to -4.7% for the life insurance industry (as compiled by Morningstar) and -2.6% for the S&P 500 ( SPY ). The last month has been especially notable, with AFL returning 17.7% .

12-Month price history and basic statistics for AFL.

AFL’s expectation-beating Q2 results , reported on August 1st, accelerated the rally in AFL, but the shares had already risen 7% above the July lows. The broader market gains in the past month, combined with an outlook for steadily rising interest rates and reduced concerns about a recession, all helped to boost AFL shares.

AFL’s Q2 results were impressive, with EPS beating expectations by more than 20%. These results extended the company’s long run of earnings that exceeded Wall Street’s expectations.

Historical (4 years) and estimated future quarterly EPS for AFL. Green values are amounts by which EPS beat expectations (Source: E-Trade).

Even with the share price increases, AFL’s valuation is reasonable. The trailing 12-month ((TTM)) P/E is 9.6, which is not particularly high by historical standards. The forward P/E is 11.9, reflecting the consensus view that earnings will fall in subsequent quarters (chart above). A P/E approaching 12 is on the upper end of historical values. The challenge for investors is that Wall Street has been underestimating AFL’s earnings growth for an extended period of time.

While the TTM dividend yield, 2.5%, is not particularly high, the company’s impressive track record of increasing the dividend should get the attention of income investors. The trailing 3-, 5-, and 10-year dividend growth rates are 11.3%, 11.4%, and 8.5% per year, respectively.

Rising interest rates tend to be good for life insurance companies because rising (falling) rates reduce (increase) the net present value of future liabilities. The discount rate applied to future payments and liabilities rises and falls with interest rates. While it is very hard to estimate an insurer’s interest rate exposure from its balance sheet, a research paper from the Chicago Fed (see previous link) notes that “the correlation between changes in an insurer’s stock price and changes in interest rates is an estimate of the interest rate risk faced by the firm.” I have calculated the rolling correlations between total return on AFL and the percentage change in 10-year Treasury yield for the last 2-, 5-, and 10-year periods. The correlation between AFL’s 3-month return and the 3-month change in 10-year Treasury yields, using the last 5 years of data, is 48%, for example.

Correlation between total return on AFL and percentage change in 10-year Treasury yield for rolling 1-, 3-, and 6-month periods over the last 2, 5, and 10 years (Source: Author’s calculations using stock price and Treasury yield data from Yahoo! Finance)

For almost all of the return periods and selections of historical data, there is a positive correlation between rising bond yields and the return on AFL. The correlation tends to get stronger (more positive) for longer return periods because the relationship between changing rates and return does not manifest instantly. In other words, a rise in rates in one month may not be reflected in the return for several months or longer. The recent Fed minutes indicating a commitment to further rate hikes will tend to provide a boost for AFL.

I last wrote about AFL on June 2nd , about 2 ½ months ago, at which time I maintained a buy rating. The company had delivered a long run of strong earnings, consistently beating expectations. As I have noted over the past year, Wall Street has tended to underestimate AFL. The Wall Street consensus rating on AFL at the start of June was neutral to bullish, and the 12-month consensus price target implied a total return of 8.3% over the next year. By contrast, the consensus view implied by the prices of AFL call and put options, the market-implied outlook, was solidly bullish into January of 2023.

Previous analysis of AFL and subsequent performance vs. the S&P 500.

For readers who are unfamiliar with the market-implied outlook, a brief explanation is needed. The price of an option on a stock is largely determined by the market’s consensus estimate of the probability that the stock price will rise above (call option) or fall below (put option) a specific level (the option strike price) between now and when the option expires. By analyzing the prices of call and put options at a range of strike prices, all with the same expiration date, it is possible to calculate a probabilistic price forecast that reconciles the options prices. This is the market-implied outlook. For a deeper explanation and background, I recommend this monograph published by the CFA Institute.

With the substantial gains in the shares in recent months, along with the Fed’s signals on rates and the reduced concerns about the U.S. entering a recession, the question is whether the shares still look attractive. I have calculated an updated market-implied outlook for AFL and compared this to the current Wall Street consensus outlook.

Wall Street Consensus Outlook for AFL

E-Trade calculates the Wall Street consensus outlook for AFL using ratings and price targets from 8 ranked analysts who have published their views over the past 3 months. The consensus rating is neutral. The consensus 12-month price target is 3.2% below the current share price. At the start of June, E-Trade calculated a Wall Street consensus rating of bullish and the consensus 12-month price target was 8% above the share price. In the months since, the share price has risen and the consensus price target has fallen.

Wall Street analyst consensus rating and 12-month price target for AFL (Source: E-Trade).

Seeking Alpha’s version of the Wall Street consensus outlook is based on ratings and price targets from 13 analysts who have published opinions in the past 90 days. The consensus rating is neutral, as it was at the start of June, and the 12-month price target is 4.3% below the current share price. The consensus price target is very slightly lower than it was at the start of June.

Wall Street analyst consensus rating and 12-month price target for AFL (Source: Seeking Alpha ).

The prevailing view among Wall Street analysts is that the recent months’ gains have pushed AFL slightly above fair value. The expected total return over the next year, including dividends, is near zero.

Market-Implied Outlook for AFL

I have calculated the market-implied outlook for AFL for the 5.1-month period between now and January 20, 2023, using the prices of call and put options that expire on this date. I chose this expiration date to provide a view into early 2023 and because the open interest on this expiration date is considerably higher than for later dates. Higher open interest tends to reinforce the belief in the representativeness of the market-implied outlook.

The standard presentation of the market-implied outlook is a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Market-implied price return probabilities for AFL for the 5.1-month period from now until January 20, 2023 (Source: Author’s calculations using options quotes from E-Trade)

The market-implied outlook is generally symmetric and the maximum probability is not meaningfully shifted to favor positive or negative returns. The probabilities of positive larger-magnitude positive returns is higher than for negative returns of the same magnitude. The expected volatility calculated from this distribution is 24.6% (annualized), as compared to 28.3% at the start of June.

To make it easier to compare the relative probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).

Market-implied price return probabilities for AFL for the 5.1-month period from now until January 20, 2023. The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from E-Trade)

This view shows that the probabilities of positive returns are consistently higher than for negative returns of the same magnitude (the solid blue line is above the dashed red line across almost all of the chart above). This is a bullish outlook for AFL. The bullish tilt is less pronounced than it was at the start of June, however.

Theory indicates that the market-implied outlook is expected to have a negative bias because investors, in aggregate, are risk averse and thus tend to pay more than fair value for downside protection. There is no way to measure the magnitude of this bias, or whether it is even present, however. Considering this potential bias reinforces the bullish interpretation of the market-implied outlook to January.

Summary

AFL has rallied in the past several months, thanks to a number of factors. First, concerns about an imminent recession have moderated. Second, the Q2 earnings were 20% above expectations, extending a long run of outperformance. Third, rising interest rates are a tailwind for life insurance companies.

The question is whether the shares have become too expensive. The Wall Street analyst consensus is that this is, indeed, the case. The consensus 12-month price target is slightly below the current share price and the consensus rating is neutral. Even with the recent gains, the valuation is reasonable by historical standards.

The consensus outlook is for lower earnings, but the analysts have consistently underestimated AFL in recent years. The market-implied outlook continues to be bullish, with moderate volatility. I am maintaining my bullish / buy rating on AFL.

For further details see: