Aflac Incorporated — Q3 2013 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2013. Aflac sells supplemental health and life insurance primarily in Japan and the United States; Japan generated 75% of nine-month revenue. Interim financial statements were reviewed by KPMG, not audited.
Financial performance
- Third quarter: Revenue was $5.886 billion, down 14.0% from $6.847 billion; net earnings were $702 million versus $1.017 billion; diluted EPS was $1.50 versus $2.16. Management attributed much of the dollar-reported decline to yen weakness.
- Nine months: Revenue was $18.138 billion, down 4.5% from $18.989 billion; net earnings rose to $2.483 billion from $2.285 billion; diluted EPS increased to $5.31 from $4.87.
- Operating earnings (non-GAAP): Q3 was $687 million, or $1.47 per diluted share, versus $831 million, or $1.77. Nine-month operating earnings were $2.236 billion, or $4.78 per diluted share, versus $2.400 billion, or $5.12.
- Investment results: Realized investment gains were $22 million in Q3 versus $286 million a year earlier; nine-month gains were $379 million versus losses of $177 million. Nine-month other-than-temporary impairment losses declined to $65 million from $643 million.
- Segments: Japan pretax operating earnings were $846 million for Q3 and $2.775 billion for nine months, down 14.9% and 7.4% in reported dollars. In yen, they increased 7.1% and 12.6%, respectively. U.S. pretax operating earnings increased 3.3% to $269 million for Q3 and 5.5% to $833 million for nine months. Japan pretax operating margins were 19.2% for Q3 and 20.7% for nine months; U.S. margins were 18.5% and 19.2%.
- Cash flow: Nine-month operating cash flow was $7.159 billion, versus $11.451 billion; investing cash outflow was $7.521 billion versus $12.499 billion; financing cash inflow was $1.133 billion versus $1.781 billion. Cash and equivalents ended at $2.749 billion, up from $2.041 billion at year-end 2012.
- Balance sheet and debt: Total assets were $119.918 billion versus $131.094 billion at year-end; total liabilities were $105.260 billion versus $115.116 billion; shareholders’ equity was $14.658 billion versus $15.978 billion. Notes payable were $4.953 billion versus $4.352 billion. Adjusted debt to total capitalization was 23.1%, versus 23.4%.
- Investment marks: Net unrealized gains on investments and derivatives in shareholders’ equity fell to $135 million from $2.6 billion at year-end, amid market movements and the weaker yen.
Material changes and management commentary
- The yen/dollar period-average exchange rate was 98.93 in Q3 2013 versus 78.64 in Q3 2012. Japan’s premiums grew in yen but translated to lower dollar revenue. At period-end, the yen was 11.4% weaker than at December 31, 2012.
- Japan new annualized premium sales fell 41.9% in yen in Q3 and 27.8% for nine months. Management cited repricing of WAYS and other first-sector life products and customer shifts toward investment trusts. Medical and cancer sales together rose 12% in Q3, supported by a new medical product.
- U.S. new annualized premium sales declined 1.5% in Q3 and 1.7% for nine months. Management described small-employer hiring and economic conditions as challenging.
- Management’s 2013 objective was 4%–7% growth in operating EPS excluding currency translation; it expected approximately 5% growth on that basis. At a Q4 yen rate of 95–100 per dollar, it projected Q4 operating EPS of $1.38–$1.43 and full-year EPS of $6.16–$6.21. For 2014, at the same exchange-rate range, it projected operating EPS of $6.28–$6.52, or about 2%–5% currency-neutral growth.
- Management raised expected share repurchases to $800 million for 2013 and $800 million–$1 billion for 2014. Nine-month repurchases totaled $298 million; cash dividends paid totaled $472 million. The board declared a Q4 dividend of $0.37 per share.
Liquidity, risks, and unusual items
- The company reported adequate expected cash flows from premiums and investments to meet benefit and expense needs. It had no borrowings under its new 50 billion yen, five-year revolving credit facility and was in compliance with debt and credit-facility covenants.
- Aflac issued $700 million of 3.625% senior notes due 2023, using cross-currency swaps to convert the obligation economically to yen at a stated 1.50% yen rate. Notes payable increased during the period.
- Aflac Japan’s solvency margin ratio was estimated at about 730% at September 30, above its 500%–600% target range, versus 585% at Q2-end. Management cited reinsurance, policy-reserve-matching investments, and interest-rate swaptions as mitigating actions. Aflac U.S.’s estimated risk-based capital ratio was about 750%, versus 630% at year-end 2012.
- Effective September 30, Aflac Japan ceded 33.3% of hospital benefits on a closed in-force block. The $652 million transaction gain was recorded as a deferred profit liability and will be recognized over the policies’ expected lives. Aflac remains liable to policyholders if the reinsurer fails to perform.
- The company released a $237 million tax valuation allowance in Q3 after previously recording it in Q2. It also changed valuation methods for certain privately issued securities in Q1, affecting fair-value measurements and hierarchy classifications; management said the resulting changes were not indicative of credit downgrades.
- Key risks include yen and interest-rate movements, investment credit downgrades and impairments, valuation uncertainty, Japan business concentration, low Japanese investment yields, derivative counterparty exposure, regulatory changes, and litigation. Management said pending litigation was not expected to materially harm financial position, results, or cash flows.
Important facts for investors to verify
- Separate underlying operating performance from translation effects and realized investment/derivative gains and losses; reconcile non-GAAP operating earnings with GAAP net earnings.
- Track Japan sales, especially WAYS repricing and growth in medical and cancer products, as well as the assumptions behind management’s EPS outlook.
- Review investment portfolio credit quality, unrealized losses, valuation methodology changes, and concentration in Japanese government and financial-sector securities.
- Assess the effect of the reinsurance transaction on Japan’s solvency margin, including reinsurer credit exposure and Aflac’s continuing policyholder obligations.
- Monitor cash generation, debt and repurchase plans, statutory capital and dividend restrictions, and sensitivity to yen and interest-rate changes.