AFLAC Reports Steady Operating Results, but Hedges Squeeze Profits

By Markets Fool.com


Even in a weak interest rate environment, Japan remains a key market for AFLAC. Image source: AFLAC.

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Specialty and supplemental insurance leaderAFLAC Incorporated(NYSE: AFL) does a lot of business in Japan, and that country has been wonderful for the company's success. Unfortunately, like any other individual economy, it also comes with its pitfalls. In Japanese yen, AFLAC reported only a 1.8% increase in premium income and a decline in investment income, but when converted to U.S. dollars, premium income was up 14.3% and net investment income was up 6.1%. That's the positive -- at least right now -- impact of currency exchange due to a strengthening yen.However, rising costs to hedge against currency impact cost the company about $0.30 per share in investment and hedging losses in the quarter.

So, how did AFLAC actually do last quarter? Let's take a closer look at the company's financial and operating results to get a better picture of its performance.

A closer look at GAAP and operating results

AFLAC reported a 2.8% increase in revenue to $5.4 billion, and reported net earnings of $548 million, down 4.4% from last year. On a per-share basis, EPS was $1.32, the same as last year thanks to an aggressive share repurchase plan that has reduced the share count nearly 6% since the start of 2015. As noted above, the negative impact of derivatives and hedges was a key reason GAAP earnings fell in the quarter. For this reason, it's a good idea to understand AFLAC's operating results in addition to its consolidated GAAP financial results.

On an operating basis, which excludes the impact of investing gains or losses, currency and other hedging activities, as well as one-time events, earnings increased 8.6% to $707 million. On a per-share basis, operating earnings were up 14%. Adjusting for currency exchange, operating earnings per share increased 8%. So as you can see, the operating business generated a pretty reasonable return, while the company's currency hedging had a negative impact. But there's even more to understand.

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Refocusing on key business lines in the current environment

Like all insurers, AFLAC makes a lot of its profit from investing premiums, making a return on this investment while it holds premiums it will largely end up paying out in claims. Historically, a key source of investment income for insurers have been interest-bearing instruments, typically of very high quality and with lower risk.

Unfortunately, Japan is in an incredibly low interest rate environment, with the Bank of Japan's negative interest rate policy making it much harder to earn a return there.Because of this environment, AFLAC has started shifting its sales focus away from its "first sector" life insurance products in Japan and putting more focus on selling its "third-sector" cancer and medical insurance products. Sales of first-sector products declined 25% in the first quarter, while sales of third-sector products were up 11%. The company said first-sector sales are expected to fall "at least 50%" in the second half of the fiscal year.

There's also the cyclical effect of global economic concerns pushing down rates in Japan as well as in the U.S. Recent events, including the Brexit vote in the U.K. and others, have put even more downward pressure on interest rates as investors continue to flock to Japanese and U.S. government bonds.

Financial housekeeping

AFLAC repurchased 5.9 million shares for $400 million in the second quarter, after having spent $600 million to buy 10.1 million in the first quarter. So that's $1 billion to repurchase 16 million shares in the first half of the year. Management said it plans to spend $1.4 billion in total this year on share buybacks, meaning investors should expect to see another $400 million spent over the next two quarters.

The company also announced it would pay a $0.41 per-share dividend on September 1 to shareholders of record as of August 24. This is approximately 5% higher than last year's Q2 dividend, and the same as paid in the first quarter of 2016.

Looking ahead

AFLAC's biggest challenge in the near term looks like it could be interest rates, as well as higher hedging costs. But long-term investors should bear in mind that these are cyclical events, and this quarter's negative impact could be next year's earnings boost. Historically, AFLAC management has generally done a good job at managing these cycles.

From an operating perspective, the company reported another solid quarter, with strong operating earnings growth and a nice per-share benefit from the company's aggressive share buyback program. Furthermore, management has implemented steps to shift its product sales mix to help offset some of the interest rate impact, and it also said it's working on investing strategies to help boost investment gains while not significantly adding to risk.

It might be some time before interest rates rise, especially in Japan, but AFLAC continues to navigate its key market well and generate solid operating results. Cycles come and go and are largely outside management's control. However, a steady hand at the wheel continues to drive solid operating results at AFLAC.

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Jason Hall has no position in any stocks mentioned. The Motley Fool recommends Aflac. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.