This report was originally published on 12/21/09.

After the close today, BCO (27.21 ↑0.55%) announced its intention to repatriate cash held in Venezuela at the “parallel rate” opposed to the “official rate”, which the company has used for accounting purposes.  BCO currently has a 61% ownership interest in its Venezeulan operations, which had $225 million in assets and $111.7 million in non-monetary assets as of 9/30/09 (based on the offical bolivar exchange rate).  The division accounted for 11% of the company’s revenues in FY08 and 12% for the first nine-months of 2009.  Operating margins for BCO’s Venezuelan operations are nearly twice the average of the company’s international operations (14-16%).

BCO’s Two Issues in Venezuela: Repatriating Cash and the Potential for “High Inflationary” Categorization

BCO faces two separate issues in Venezuela (excluding the difficulties of operating in that country): the government’s reluctance to honor the “official exchange rate” for bolivars to dollars of 2.15 and the risk that the country could be labeled “highly inflationary” for accounting purposes.

Repatriating Cash at the Official Rate Appears Unlikely

BCO has attempted to repatriate its cash held in bolivars at the official rate of 2.15 bolivars/dollar (compared to the market rate of 6.20) for sometime now.  There are growing concerns that Hugo Chavez could choose to devalue the bolivar given the country’s fiscal issues and high inflation levels.   There are a number of multi-national companies that have significant exposure to the Venezuelan bolivar.  The Chavez regime is concerned about a run on the bolivar and has tried to prevent large companies from taking cash out of the country by not allowing conversion of cash holdings into dollars at the official rate.  We have not had the opportunity to speak with BCO management specifically as to what served as the catalyst to repatriate cash at the parallel rate (aka market). We can only speculate that recent actions by the Chavez regime to seize a select number of private banks and other examples of anti-corporate “sabre rattling” led the company to the decision that conditions for corporations in Venezuela could get worse or another spout of high inflation could be imminent.

The Financial Implications of Shifting to the Parallel Rate (aka Market Rate) for Bolivars

As we mentioned earlier, BCO has operated in Venezuela for decades and this is not the first-time the company has dealt with inflation risks or fascist regimes.  Going forward the financial implications of the decision to use the parallel rate for accounting purposes is as follows:

• BCO will repatriate 75 million bolivars at 6.20/1 USD, yielding $12 million opposed to the $35 million that was reflected on the  company’s balance sheet as of 9/30/09 (using the official rate of 2.15/1)
• In the fourth quarter the company will record a cash charge of $23 million as a result of the differences between the parallel and the official rate
• On a going forward basis, BCO will account for its operations in Venezuela based on the parallel rate.  Assuming the company adopted this policy on 1/1/09, revenues would have been reduced by $177 million (7.4%) and EPS by $0.27 (14%) on a year-to-date basis.

The financial implications of moving to a parallel rate are significant to say the least.  BCO has decided to take a more conservative accounting tact.  As far as we know there is no official “parallel rate” that is published, but the most recent rate is closer to 5.85-5.95/dollar.  It is important to note that the exchange rate has traded in a huge range over the past 4-5 years.  According to IncaKola the parallel exchange rate for Venezuela bolivares to USD has ranged from 2.60/1 USD to 6.90/1 USD from 1/1/06 through this year.  Given the Venezuelan economy’s reliance on crude oil production, historically the exchange rate has been highly correlated to oil prices, excluding other geo-political factors.  If oil prices were to suddenly increase we would expect the exchange rate to come in rather quickly.  Alternatively if Chavez were to take rash action (privatizing the banking system would be an example) we would expect the exchange to widen out further.

Venezuela’s Potential Classification as Highly Inflationary Is a Separate Issue

We wanted to make it clear that the potential that Venezuela could be classified as “highly inflationary” for accounting purposes is actually a separate issue (albeit related).  Recently the SEC Regulations Committee’s International Practice Task Force indicated that Venezuela could be categorized as highly inflationary for accounting purposes on 1/1/10 based on inflation trends.  The threshold for a country to be deemed highly inflationary is a three-year cumulative inflation rate of 100%.  As of 6/30/09, the cumulative inflation rate in Venezuela was 101.4% using the traditional measure of CPI.  However in 2008 a new measure of inflation was introduced in Venezuela, a national CPI.  The national CPI covers the entire country oppossed to the traditional measure of CPI which was based on price trends in Caracas and Maracaibo.  Under the national CPI three-year inflation was closer to 95%.  The SEC task force has indicated it will accept the use of a blended rate between the traditional CPI measure and more recently introduced national CPI metric.  For those interested, you can read more here.

The determination of whether or not Venezuela is deemed highly inflationary for accounting purposes will have a significant impact on BCO’s GAAP results.  The company’s effective tax rate would increase from 29% to 36% if Venezuela is deemed highly inflationary.  BCO’s stock has rallied in recent weeks in response to November CPI data (Caracas/Maracaibo) that came in below expectations.  At this point, it appears that Venezuela will not be labeled as highly inflationary for accounting purposes next year, particularly if BCO chooses to use the blended option of the traditional CPI and the new national CPI.  The determination will be very close and could change based on events that transpire over the next two weeks.

Estimate Implications of the Parallel Rate

The situation in Venezuela has been an enormous overhang on BCO shares for most of this year.  Today’s announcement only adds to the uncertainty. Going forward, a meaningful portion of the company’s operating income will be dictated by changes in the Venezuelan bolivar, which can often be violent.  We think it is interesting that the decision to use a parallel rate for its Venezuelan operations creates a natural hedge in BCO’s financials to rising crude oil prices.  For now we have assumed that the parallel exchange rate in Venezuela does not change in 2010.  Here are are estimate revisions:

• We previously thought the company could generate EPS of $2.25-$2.40 based on mid-single digit organic revenue growth and a 2-4% benefit from currency
• Our revised revenue estimate is $3.17B (vs. $3.26B consensus)  which assumes the company generates $122 million in revenues from Venezuela (on a USD basis), 20-25% revenue growth in other emerging markets, and 5-7% revenue growth in the company’s core US and European markets
• Our revised EPS estimates is $1.87, which assumes the company’s tax rate is 30% for 2010 (Venezuela is not deemed highly inflationary).
• We antipate earnings could be as low as $1.60-$1.70 for 2010, in a scenario in which the bolivare exchange rate stays at 6.20/1 USD AND Venezuela is labeled highly inflationary.

There is no way we can construe today’s announcement as a positive development.  However, we note that the  company continues to reduce its relative exposure to Venezuela through expansion into other emerging markets.  On a going forward basis, BCO’s platform in Asia will now be as large or bigger than its operations in Venezuela from a financial perspective.  Perhaps more importantly, the company’s free cash flow profile remains robust.  The stock was already discounting a negative outcome in Venezuela, which is a primary reason why we think shares traded at 12.5x consensus for CY10 despite BCO’s strong secular growth story and high returns on invested capital.  It is important to note that the stock closed today at 15.7x our downside scenario estimate for 2010.  We think the name could be poised for multiple expansion as cash-in-transit volumes improve, the transport of diamonds grows and investors increasingly focus on the other elements of BCO’s growth story outside Venezuela.

As always, please act accordingly…

Disclaimer: The author of this report owns call options in BCO.  Positions can change at any time without notice.