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Aflac Inc.’s (AFL - Analyst Report) second-quarter 2012 operating earnings per share of $1.61 came in line with the Zacks Consensus Estimate, but it modestly surpassed the year-ago quarter’s earnings of $1.55. Operating earnings climbed 3.9% year over year to $755 million. A stronger yen/dollar exchange rate boosted the operating earnings by 1 cent per share.

Operating earnings in the reported quarter excluded after-tax negative impact of realized investment losses from securities transactions and impairments of $228 million or 49 cents per share compared with $480 million or $1.03 per share in the year-ago quarter. Additionally, a negative impact of derivative and hedging activities worth $44 million or 9 cents per share affected the operating earnings in the reported quarter, as opposed to the positive impact of $27 million or 6 cents per share recorded in the year-ago period.

Including one-time items, Aflac’s GAAP net income in the reported quarter surged 76.6% to $483 million or $1.03 per share against $274 million or 58 cents per share in the year-ago period. Total acquisition and operating expenses moved up 4.8% year over year to $1.40 billion, while benefits and claims spurted 13.7% year over year to about $3.76 billion.

Total revenue for the reported quarter spiked up 16.0% year over year to $5.9 billion, but lagged the Zacks Consensus Estimate of $6.23 billion. Despite the ongoing derisking activities and the low-rate environment, total revenue benefited from modest strengthening of yen against the dollar along with consistent improvement in the U.S. and Japan. While Aflac Japan contributed 83% to the total revenue, Aflac U.S. contributed the remaining 17%.

Total revenue in Japan increased 11.2% year over year to $4.9 billion. Reflecting the stronger average yen and accelerated sales from bank channel and WAYS product, premium income from the Japanese operations in terms of dollars was up 11.8% year over year to $4.2 billion in the reported quarter.

Net investment income from the Japanese operations increased 8.6% year over year to $691 million, primarily spurred by a stronger yen/dollar exchange rate, which was 80.19, or 1.7% stronger than the average rate of 81.57 in the year-ago quarter. Consequently, pre-tax operating earnings in Japan climbed 4.2% year over year to $964 million.

Aflac U.S. generated revenues of $1.4 billion, up 5.2% over the prior-year quarter. Net investment income from the U.S. operation saw an uptick of 3.6% year over year to $153 million. Premiums from the U.S. operations were up 5.5% year over year to $1.3 billion. Despite the lingering weakness in the U.S., total new annualized sales climbed 1.5% year over year to $359 million as the broker channel showed improvement and are taking up initiatives to reach out to the brokers of the large-and small-case employer markets, thereby outpacing for the sixth consecutive quarter.

Subsequently, pre-tax operating earnings in the U.S. climbed 6.3% year over year to $258 million, while persistency improved to 76.6% from 75.2% in the year-ago quarter.

Financial Update

As of June 30, 2012, total investment and cash were $109.3 billion compared with $103.46 billion at 2011-end, while shareholders' equity totaled $14.2 billion as against $13.50 billion at the end of 2011. Shareholders' equity per share was $30.37 at the end of the reported quarter, up from $27.76 per share reported at the end of 2011 and $29.19 per share in the prior quarter.

At the end of the reported quarter, Aflac projected its risk-based capital ratio in the range of 560–600%, compared with 493% at 2011-end, while its solvency ratio in Japan is also at the higher end of 500–600% target. During the reported quarter, net unrealized gain on investment securities and derivatives were $1.5 billion as compared with $1.4 billion in the prior quarter.

However, annualized return on average shareholders’ equity for the reported quarter was 13.9% against 23.6% in the prior quarter. On an operating basis (excluding realized investment losses and the impact of ASC 815 on net earnings, and unrealized investment gains/losses in shareholders' equity) Aflac’s return on average shareholders’ equity came in at 24.0%, up from 27.1% in the previous quarter.

Guidance

Concurrent with the release of second quarter’s result, Aflac reiterated its 2012 outlook. The company expects revenues from Aflac Japan to increase about 10% in 2012, way higher than the prior band of -2% to 5%. The revenue projection for Aflac U.S. is reiterated at 3–8%. Annual premium sales are expected to be within 22–25% in 2012, while new annualized sales are projected to grow by 0–5% in the second half of 2012, reflecting difficult comps. However, management expects sales to improve going ahead, as the majority of the enrolments are scheduled to occur during the fourth quarter.

Additionally, management reaffirmed its earnings guidance for 2012 in the range of 3–6% over 2011, excluding the effect of foreign currency fluctuations. This also reflects the impact of new accounting for deferred acquisition cost (DAC) by approximately 5 cents per share and portfolio derisking.

Accordingly, if the yen averages 80 against dollar, the earnings growth is expected to be within $6.45–6.52 per share for 2012, at the lower-end of prior band of $6.46–6.65 per share based on low investment yields.

Based on this exchange rate assumption, management provided its third quarter earnings expectation in the range of $1.64–1.69 per share. Excluding currency fluctuations, Aflac anticipates the earnings growth to improve by 4–7% in 2013.

Dividend Update

Concurrently, the board of Aflac announced a regular cash dividend of 33 cents per share, which is payable on September 4, 2012 to its shareholders of record as on August 15, 2012.

Earlier, on June 1, 2012, Aflac paid a dividend of 33 cents per share to its shareholders of record as on May 16, 2012. The company had hiked its dividend by 10% to 33 cents in October 2011.

Our Take

Over the years, Aflac has been significantly focusing on strengthening its insurance operations through successful product launches and the expansion of its distribution system, which has been significantly contributing to its strong sales results. This has also enabled the company to generate healthy capital ratios and cash position, while raising dividends from time to time. However, higher operating expenses continue to be a deterrent for desired advancement.

Although the near-term outlook remains cautious, given the effect of portfolio derisking activities and the continued low-interest-rate environment in Japan that is also reflected in the company’s guidance, we believe that the will gather momentum economy in the long term and negate interest and currency risk, thereby providing more profitable investment opportunities to Aflac. Going ahead, the company’s strong capital and surplus cash position is expected to mitigate balance sheet risks and provide liquidity cushion in the long run, as well as return value to shareholders consistently.

Hence, we continue to retain our Neutral stance on the stock, with a Zacks Rank #3, implying a short-term Hold rating. Meanwhile, Aflac’s peer Unum Group (UNM - Analyst Report) is slated to release its results after the closing bell on August 1, 2012.

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