Aflac Incorporated — Q2 2013 Form 10-Q
Business context and period. This unaudited quarterly report covers the three and six months ended June 30, 2013, with comparisons to 2012. Aflac sells supplemental health and life insurance in the United States and Japan; Japan represented 75% of first-half 2013 revenue, including realized investment gains and losses. KPMG reviewed the interim statements and reported no material modifications needed for GAAP conformity; this was a review, not an audit.
Financial performance
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Total revenue | $6.044 billion | $5.902 billion | $12.252 billion | $12.142 billion |
| Net earnings | $889 million | $483 million | $1.781 billion | $1.268 billion |
| Diluted EPS | $1.90 | $1.03 | $3.80 | $2.71 |
| Pretax operating earnings | $1.157 billion | $1.159 billion | $2.362 billion | $2.406 billion |
| After-tax operating earnings, non-GAAP | $759 million | $755 million | $1.549 billion | $1.569 billion |
| Operating earnings per diluted share, non-GAAP | $1.62 | $1.61 | $3.31 | $3.35 |
- Revenue increased 2.4% in Q2 and 0.9% in the first half. Net earnings rose sharply, principally reflecting the swing in realized investment results: Q2 recorded $201 million of pretax gains versus $418 million of losses a year earlier; first-half gains were $357 million versus losses of $463 million.
- Operating earnings per diluted share, which exclude realized investment gains and losses and nonrecurring items, were nearly flat in Q2 and down about 1% for the first half. Approximate operating-earnings margins on reported revenue were 12.6% in Q2 and 12.6% for the first half; these are calculated ratios, not company-reported measures.
- Q2 premiums were $5.013 billion versus $5.467 billion; first-half premiums were $10.197 billion versus $10.845 billion. Lower Japan premiums translated into dollars were a key factor. Net investment income was $813 million in Q2 and $1.646 billion in the first half, down from $845 million and $1.728 billion, respectively.
- Six-month operating cash flow was $5.698 billion, down from $7.245 billion; investing cash outflow was $5.810 billion versus $8.058 billion. Financing cash inflow was $526 million versus $725 million. Cash and equivalents ended June at $2.388 billion, up from $2.041 billion at year-end.
- At June 30, total assets were $116.313 billion, liabilities $102.617 billion, and shareholders’ equity $13.696 billion, compared with $131.094 billion, $115.116 billion, and $15.978 billion at December 31. The weaker yen materially reduced translated balance-sheet values. First-half other comprehensive loss was $3.555 billion after tax, largely from unrealized investment losses and foreign-currency translation; accumulated other comprehensive income moved from $2.715 billion to a loss of $840 million.
- Notes payable were $4.946 billion, up from $4.352 billion; the adjusted-debt-to-total-capitalization ratio was 23.9%, versus 23.4%. Aflac issued $700 million of 3.625% senior notes due 2023. Cash dividends were $0.35 per share in Q2, versus $0.33 a year earlier.
Changes, segments, and management commentary
- Aflac Japan: First-half pretax operating earnings were $1.929 billion versus $2.004 billion; in yen, they increased 9.3% excluding foreign-currency effects. Q2 new annualized premium sales fell 53.7% in dollars and 43.1% in yen. Management cited repricing of WAYS and other life products, and a shift by bank customers toward investment trusts. Japan annualized premiums in force increased 8.0% in yen.
- Aflac U.S.: First-half pretax operating earnings rose to $564 million from $529 million. Q2 new annualized premium sales rose 1.4%; first-half sales fell 1.9%. Management cited weak hiring, particularly among small employers, and uncertainty around health-care reform.
- The yen averaged 98.76 per dollar in Q2 2013 versus 80.19 a year earlier, reducing reported Japan results. Management characterized translation as a financial-reporting effect rather than an economic event for the company.
- The company recorded $55 million of first-half pretax other-than-temporary investment impairment losses, versus $546 million in the first half of 2012; Q2 2013 had none. Realized gains also included $207 million of first-half derivative and other gains. These market-sensitive items materially affected GAAP earnings.
- In Q1 2013, Aflac changed its valuation methodology for certain privately issued securities, using an outside pricing vendor and revised models. Management said the change affected fair-value estimates and related disclosures; it also contributed to the reported shift in unrealized values.
- Management targeted 4%–7% growth in 2013 operating EPS excluding currency translation, but expected approximately 5% growth for the full year given increased second-half spending. With yen at 95–105 per dollar, it projected Q3 operating EPS of $1.41–$1.51 and full-year operating EPS of $5.83–$6.37. The company planned $600 million of share repurchases in 2013 and indicated $600–$900 million in 2014.
- Management expected higher Japan advertising and promotion costs for an August product launch and increased U.S. costs related to health-care reform. It expected Japan cancer and medical sales to be flat to up 5% for 2013 and U.S. benefit and expense ratios and pretax operating margin to be similar to 2012.
Liquidity, risks, and contingencies
- Aflac reported no borrowings under its new five-year, ¥50 billion revolving credit facility at quarter-end and said it was in compliance with debt and credit-facility covenants. Management stated that expected cash flows from premiums and investments should meet benefit and expense needs.
- Estimated Japan solvency margin ratio was approximately 585%, down from 686% at Q1 and within management’s 500%–600% target range. The decline was attributed mainly to higher U.S. and Japanese interest rates reducing fair values of available-for-sale investments. The credit facility serves as a capital contingency plan.
- A 100-basis-point increase in market interest rates was estimated to reduce the fair value of debt and perpetual securities by approximately $12.1 billion. Aflac said it generally intended and was able to hold securities until recovery or maturity, but valuation, interest-rate, currency, and credit risks remain relevant.
- Investment risks include Japan concentration, exposure to banks and financial institutions (16% of the portfolio at fair value), perpetual securities, downgraded holdings, and European sovereign and issuer risks. Management reported no direct exposure to Greece or Cyprus. The company said it had no material off-balance-sheet letters of credit, guarantees, or standby repurchase obligations.
- Aflac was involved in lawsuits in the ordinary course of business and did not expect pending litigation to materially adversely affect its financial position, results, or cash flows. Forward-looking risks also include foreign exchange movements, investment defaults and downgrades, regulation, operating-system and data-security issues, and policyholder experience deviating from assumptions.
Most important facts for investors to verify
- How much reported earnings growth came from investment and derivative gains rather than underlying insurance operations, and whether operating EPS guidance was achieved.
- Whether Japan sales recovered following product repricing and the August launch, given the steep Q2 decline in new annualized premium sales.
- How yen movements and higher interest rates affected reported results, investment marks, and Japan’s solvency margin.
- The performance and credit quality of the investment portfolio, especially bank and perpetual-security exposures, downgraded holdings, and fair-value estimates under the revised methodology.
- Execution of planned repurchases, debt refinancing, Japan profit remittances, and the availability of capital at regulated subsidiaries.