This report was originally published on 10/26/09.

We introduced the Brink’s Company (BCO 27.05 ↓0.04%) as what we thought would be a compelling long idea a few months ago based on the company’s strong track record of secular growth over the past 25-years, solid free cash flow generation (10%+ yield), high returns on invested capital (20%+), and compelling valuation.  You can read our original report here.  Thus far the trade has not worked.  BCO shares have languished, while the market has ripped.  Overall the stock has underperformed the market by more than 25%. We attribute the relative underperfomance of BCO shares to two primary factors: 1) weak quarterly results caused by a precipitous decline in diamond traffic and substantial currency headwinds, and 2) concerns about BCO’s underfunded pension plan.  The company resolved the funded status of its primary pension plan by contributing $150 million to it in August.  The contribution was funded with a combination of debt and equity.  The capital infusion from the company combined with appreciation of stock prices should leave the pension fund meaningfully closer to fully funded at year end.  Additionally, due to tax treatment of the pension contribution, BCO management estimates the transaction will be $0.02 accretive to FY09 results and $0.04 to FY10 results.  Additionally, the company will not be required to make a capital contribution to its pension fund in FY10, which should enable BCO to continue to pursue strategic acquisitions and repurchase stock.  You can read some more detail on the company’s most recent results and pension fund contribution here.

The fundamental overhang on BCO shares can only be resolved through solid execution.  In this environment, most companies we follow would welcome the ability to generate 2% YOY organic revenue growth, which is what BCO did in the second quarter. The overall resiliency of BCO’s cash-in-transit and ATM end-markets have more or less been ignored due to the negative operating leverage created by a sharp fall-off in “value-added services” activity, primarily in the transportation of diamonds.  Fortunately, there are increasing signs that transaction activity in both rough and polished diamonds has started to pick-up, which should benefit BCO’s 3Q09 results.

Rough and Polished Diamond Traffic Starting to Pick-Up

We have discussed the increase in the global rough diamond trade over the past few months in the context of our pair trade idea: Long Signet (SIG 29.43 ↓1.31%) Jewelers/Short Blue Nile (NILE 55.23↑0.64%).  You can read our most recent report on diamond prices here.  In the first half of 2009, there was little to almost no activity in the diamond market.  DeBeers cut production by 90%+ in the first quarter of 2009 and ZAO Alrosa, the second largest producer of diamonds in the world did not sell a single diamond outside of purchases by the Russian government.  Over the past 8-12 weeks there have been growing signs that 1H09 represented a trough and transaction volume of diamonds has increased substantially on a sequential basis.  As a leading provider of global transportation services for diamonds, we expect BCO to be a direct beneficiary of increased activity.  Let’s take a look at import/export volumes in three of the largest diamond markets in the world: the US, India and Israel.

The U.S. is primarily a polished diamond market.  There is very little transaction activity in rough diamonds, even though the U.S. is the largest diamond market in the world.  According to the Rapaport Group, the dollar value of polished imports declined 35% YOY in the month of August to $893 million.  However, the total number of carats imported decreased only 9% YOY to 973,000.  This is the lowest level of decline in carat volume imported thus far this year.  More importantly, as the chart below demonstrates import and export volume on a dollar value basis increased for the second consecutive quarter sequentially.  Additionally, the “net diamond account” which is the dollar value of polished imports less the dollar value of exports was still down 55% YOY, which suggests that there is room for inventory levels of polished diamonds in the U.S. to increase.

Source: Rapaport Group, PAA Research

The trends look remarkably similar in India, although India is a much larger importer of rough diamonds than is the US.  Diamond polishing is a huge industry in India.  In the third quarter, polished diamond exports from India increased 50% YOY on a dollar volume basis and 35.4% on a per/carat basis compared to second quarter levels.  Additionally, total polished diamond exports increased on a YOY basis in the month of September.  Overall the total number of exports (rough and polished) increased 49% sequentially from  the third quarter, while the total number of imports increased 17.6%.

Source: Rapaport Group, PAA Research

Finally, in Israel, which is a considerably smaller diamond market than the US, but still critically important, total diamond imports and exports have increased sequentially Q/Q for each of the past two quarters.

Source: Rapaport Group, PAA Research

We do not expect transaction volumes in the diamond industry to return to pre-2008 levels anytime soon, but it is important to note that trends are clearly improving. This should provide a favorable tailwind for BCO’s 3Q09 and 4Q09 results.  The company generates approximately 30-35% of its revenues from “value added services’, which include the company’s compusafe product as well as the transportation of valuables (aka diamonds/jewelry) on a global basis.  Value added services are higher margin than the company’s core cash in transit and ATM servicing offerings.  We think increased stability in the diamond market could enable BCO to exceed consensus expectations and return investor focus to the company’s strong secular growth, high returns on capital and compelling free cash flow generation.

Currency Going from a Headwind to a Tailwind

BCO generates more than 70% of its revenues outside of North America. Although the company incurs a significant portion of its costs in local currencies, the company’s operating margins still are leveraged to a weak dollar.  For the first half of the year, currency represented a 10%+ headwind for BCO’s revenue growth.  This headwind should be significantly reduced in the third quarter. We currently estimate that currency will represent a 6% headwind to the company’s 3Q09 results for its international operations.  In the fourth quarter, we expect currency to become a favorable lift to revenue growth of as much as 10% YOY.  Based on current monetary and fiscal policies in the U.S. we expect dollar weakness to become a fixture.

Source: Company reports

BCO Shares Are Remarkably Cheap

BCO now trades at a meager12.6x our FY09 EPS estimate and 4.4x on an EV/EBITDA basis.  We think the company’s third quarter results could be the catalyst for investors to refocus on BCO’s secular growth story and impressive returns on invested capital (20%+).  Current street consensus implies a 3.5-4.0% sequential increase in revenues from 2Q09 to 3Q09, which could be conservative given the strong increase in global diamond transaction activity and sell-off in the dollar during the quarter.  The table below highlights some of our estimates for 3Q09, 2009 and 2010 for BCO.  After delivering disappointing quarterly results and dealing with the pension overhang, we think BCO might finally be positioned to deliver earnings upside.

(1) 2009 Free Cash flow estimate excludes one-time $150MM pension contribution

We think the stock could be poised for significant multiple expansion.  Business services stocks that have a long track record of organic growth, generate sizeable free cash flow and produce 20%+ returns on invested capital typically trade between 16-20x FY2 EPS.  On that basis, BCO shares could trade as high as $38-$42/share, which is 50-65% above current trading levels.

As always, please act accordingly….

Disclaimer: The author of this report is long calls in BCO. Positions can change at anytime without notice.