An Undervalued Industry Leader with +66% Upside Potential

It took a talking duck to make one of the largest insurance companies rise from obscurity to one of the most recognized names in the business.

Aflac Inc. (NYSE: AFL) provides health insurance for 40 million people worldwide and has received numerous awards for being the best-managed and most ethical company in the insurance category. It should have one more award to its name: The most investor-friendly insurance company.

Growth-, income- and value-oriented investors will all find something to love about Aflac. It has increased earnings per share for 18 consecutive years. It has increased its dividend payments for 26 straight years. And it trades at a -40% discount to its historical valuation.

Aflac sells supplemental insurance in the two largest insurance markets, Japan and the United States. Supplemental insurance is designed to pay for out-of-pocket expenses not covered by primary insurance policies. Aflac is offered to employees at the work place, usually at no cost to the employer. Its workplace-based distribution system reduces the cost of acquiring customers.

Aflac is based in the United States but generates 72% of its revenue in Japan. The company provides insurance for 89% of the 2,334 companies listed on the Tokyo Stock Exchange and is the number one provider of health insurance in Japan. During the past five years, Aflac has increased operating income, which excludes income from investing activities, in its Japan branch to $2.2 billion from $1 billion, a +17% annualized growth rate.

Aflac’s presence is not as large in the United States, but it’s growing.

More than 450,000 U.S. companies offer Aflac to their employees. But there is still plenty of room to grow — only 6% of small businesses currently offer Aflac. Operating income has increased to $745 million from $451 million during the past five years, a +10.5% annualized growth rate. Not bad considering the weak economic conditions.

The main culprit has been the economy. High unemployment has reduced the size of Aflac’s customer base. And people who did have jobs were less likely to purchase additional insurance amid a recession.

The bearish stock market in the latter part of 2008 into early 2009 resulted in investment losses for Aflac, along with most insurance companies. Premiums paid by policyholders are usually invested to generate additional income. Slumping share prices reduced the value of those investments, forcing insurance companies to write-down assets, or lower the book value of their assets to reflect current market prices.

The stock market has obviously improved during the last year, and the worst seems to be in the rear view acquiring. Aflac’s investment losses were -$226 million in the third quarter ended September 30, 2009, compared with -$389 million in the year-earlier period.

Two key factors set Aflac apart from most U.S. health insurance companies. For one, since the bulk of Aflac’s revenue comes from its operations in Japan, any negative impact from a U.S. health care bill on the insurance industry likely wouldn’t cut as deeply.

Second, Aflac focuses on selling insurance to protect policy holders from loss of income due to an accident or illness. The U.S. government already has programs in place to cover lost income, such as Supplemental Security Income program and Social Security Disability program.

However, the payments are usually not enough to cover medical and everyday expenses associated with unemployment. In fact, medical expenses cause about 62% of all bankruptcies in the United States, and three-quarters of those who cite medical expenses as the cause have health insurance. Obviously, there’s still a need for supplemental insurance.

Since most of Aflac’s revenue stems from Japan, the shares can serve as a currency hedge against a falling dollar. In the third-quarter, the average yen/dollar exchange rate fell -15% compared with the third-quarter of 2008. That means earnings looked more impressive in dollar terms since the dollar was cheaper in yen terms.

Aflac’s shares pay a $0.28 quarterly dividend per share for a yield of 2.3%. Its long history of increasing earnings has allowed it to raise dividend payments for 26 consecutive years. The dividend has grown at an annualized growth rate of +24% for the past five years.

Shares of Aflac have risen +27.8% during the past year, compared with +33.9% for the S&P. During the past five years, however, shares of Aflac have outperformed the S&P by +34.4%.

That doesn’t mean the shares are expensive. Aflac’s shares are trading at an earnings multiple of 9.2, a steep -40% discount to their five-year average earnings multiple of 15.3. Now could be a great opportunity to buy shares of a great insurance company at a discount.