BCO reported 2Q10 results this morning. You can read the full earnings release here. Overall, the company delivered both topline and bottomline outperformance for the first time in many quarters. Although management tempered its full year operating margin outlook in conjunction with its 2Q10 earnings release, we think the quarter could represent an inflection point for BCO”s revenue, earnings, and free cash flow prospects.  The company faces several operating challenges in key markets in North American and Europe, but at long last it appears that BCO is starting to benefit from a modest amount of operating momentum.

Positive Tailwinds Starting to Outweigh Ongoing Headwinds

In a recent report on BCO, we argued that shares were poised to witness upside as the company’s “death by 1000 cuts” in 2009 came to an end.  With the stock down 9.7% YTD, our call has been less than prescient.  As a reminder, here were the issues the company faced in 2009:

• A deeply underfunded pension following the 2008 market collapse, which caused the company to contribute $150 million to its U.S. pension plans during 3Q09.
• Political instability in Venezuela which led management to the decision to repatriate cash from its Venezuelan subsidiary at 5.92 bolivar/dollar (in the fourth quarter) compared to what used to be the stated exchange rate of 2.15 bolivar/dollar.
• An incredibly weak demand environment for diamonds and other precious jewelry, which severely hampered financial results for the company’s higher margin value added services
• Competitve pressures in Europe, the company’s single largest operating segment, which hurt organic growth and operating margins over the course of the year

Realistically, only two of the four issues (pension funding and Venezuela) discussed above have been resolved in full in 2010.  The company’s operating earnings continue to be plagued by competitive pressures in Europe and while the diamond trade has improved, it is still well below 2008 levels.  In addition to the aforementioned issues, BCO faces an incredibly competitive pricing environment in North America. Management described pricing actions by its competitors in North America as “irrational”.  We are encouraged that BCO was able to deliver revenue and earnings upside for 2Q10 despite these significant headwinds.

Positive Tailwinds Should Drive Solid Organic Revenue Growth and Modest Margin Expansion Going Forward

We have identified six factors that should serve as favorable tailwinds to BCO’s revenue, earnings, and free cash flow growth over the next 12-18 months. More importantly, we think these tailwinds should more than offset the considerable headwinds the company faces in the form of competitive pricing in the US and lackluster economic growth in Europe.  The six factors are:

1) Robust growth in Latin America. For each of the past two quarters, BCO has generated double digit organic revenue growth.  While the accounting treatment of the company’s Venezuelan operations as “highly inflationary” has created a degree of uncertainty in the company’s financial statements in the first half of the year, this should not overshadow the compelling fundamentals in the rest of Latin America for BCO.  The company should continue to benefit from relatively strong GDP growth, expansion of cash in circulation, and a rapid increase in the installed base of ATM’s in Brazil, Argentina, and to a lesser extent Chile.  Latin America now represents 37% of international revenues and 25% of total companywide revenues.  For the next 6-12 months it appears BCO’s Latin American operations can boost revenue growth by as much as 3-5% on a YOY basis.

2) Improvement in the diamond trade.  The velocity of the diamond trade in major markets such as the US, India, and Israel has improved considerably thus far in 2010.  No one would characterize consumer appetite for diamonds in the US as robust, but it is improving gradually.  According to IDEX Online, consumer prices on diamonds started to increase on a month-to-month basis in October of 2009 and posted the first positive YOY comparison in February of this year.

Additionally, polished diamond imports to the US have increased on a YOY basis for six consecutive months according to the US Commerce Department.  Most specialty jewelry retailers we have spoken to have been almost exclusively focused on inventory reduction over the past 12-18 months.  The sharp reduction in diamond prices left many jewelers with inventory that was “underwater”.  Based on the data from the Commerce Department, it appears that inventory de-stocking is approaching its final phase and jewelers should be able to take on lower cost diamond inventory (remember some retailers were still holding diamond inventory priced at 2008 levels).  Reasonably strong sell through for the holiday season will be critical towards sustaining the positive momentum in polished diamond imports in the US.

India has become one of the largest diamond markets in the world.  Generally speaking the country is an importer of rough diamonds and an exporter of polished diamonds.  India benefits directly from strong end-market demand in the rest of Asia for diamonds and other jewelry products. As a result, polished diamond exports thus far this year are up strongly YOY and compared to 2008 levels.

BCO’s global footprint is a clear differentiator relative to its competitors and should enable the company to gain market share in the transportation of diamonds and other high value items over the next several years as volumes recover.

3) Growth in the installed based of Compusafe.  Compusafe, BCO’s proprietary closed loop system to help retailers reduce theft, improve working capital turns, and manage cash has achieved rapid acceptance. In 2009, Compusafe’s installed based increased by 37% over 2008 levels. There are now more than 11,000 retailers using Compusafe at the point of sale. During the second quarter, the installed base of Compusafe increased by a net 400 locations. It appears that Compusafe growth is trending below management’s initial expectations for 2010 of 30-40%.  We still think the company can increase the installed base by as much as 25-30% this year.  Sales from Compusafe accounted for 7% of BCO’s total North American revenues and 2% of the company’s total in 2009. Although Compusafe is not a huge contributor to BCO’s topline at this stage, it has achieved enough critical mass that it can boost the company’s total revenue growth by 50-100 bps annualy for the next 3-4 years in our opinion. Additionally, Compusafe is a higher margin revenue stream than the company’s traditional cash in transit services.

4) Benefits from cost-cutting and other restructuring efforts.  The overall market environment in Europe is likely to remain weak for cash in transit and ATM services for the foreseeable future (unless the Euro falls apart, which would be positive for BCO).  The company has taken several steps to improve profitability in Europe over the past 12-months, which only started to show up in earnings in 2Q10.  Although profitability levels in Europe are still below the average margin for BCO’s international operations, considerable progress has been made.  Severance and other restructuring costs will be considerably lower than they were for 2H09 and 1Q10.  It appears the hiring of new management, efforts to “right-size” the cost structure, and decisions to exit low return businesses in the past 6-12 months should lead to improved profitability in Europe even if end-market trends do not change meaningfully.

5) Resolution of the Venezuela accounting issue (for now).  As a result of BCO deeming its Venezuelan operations as “highly inflationary” for accounting purposes, the company has been required to mark to market its assets in that country in US dollars on a quarterly basis. Changes in the value of the assets run through BCO’s P&L quarterly.  By the end of the first quarter, the company reduced its cash holdings in Venezuela through a series of dividends and had total assets of $28 million.  Over the course of the second quarter the pressure on the Venezuelan bolivar continued to mount and the parallel rate widened out to 8.9 bolivar/USD.  As a result, BCO marked its assets intra-quarter to a low of $14 million.  In June, the Venezuelan government elected to abolish the “parallel exchanges” and allow a maximum of $350,000 per legal entity per month to be converted into dollars at a rate between 4.3-5.3 bolivars/USD.  As a result, BCO marked its assets in Venezuela to $23 million at the end of the second quarter. Going forward, we do not expect BCO to witness the same type of volatility in its mark-to-market for its Venezuelan assets on a quarterly basis, unless of course the government’s new program breaks down.  However, the company will not be able to repatriate a meaningful amount of cash from the country going forward.  Overall, BCO has taken substantial steps to reduce its asset exposure in the region.

6) Robust free cash flow generation and balance sheet strength.  BCO closed 2Q10 with a meager $119 million in net debt, not even half a turn of EBITDA.  Even though free cash flow generation through the first six months of 2010 has declined on a YOY basis, we still expect BCO to generate $100MM+ for the full year.  In the past month, BCO repurchased 1.1 million shares, which we think serves as a testament to the company’s outstanding financial flexibility. We expect the company to continue to pursue its tuck-in acquisition strategy and selectively repurchase shares depending on the stock price.  Both strategies should lead to improved returns for shareholders.

Revising Estimates to Reflect Competitive Pressures in the US and a Stronger US Dollar

In the table below we outline our forecasts for 3Q10, 2010, and 2011.  Overall we have lowered our estimates to reflect lower operating margins in the US, slightly slower growth in North America, and a weaker Euro.  For both 2010 and 2011, we expect the company to generate approximately 4% topline growth (net of currency impacts) and benefit from solid operating margin expansion.  From a free cash flow perspective, the company has reduced its CAPEX plans for 2010, which should enable BCO to generate more than $120 million this year.

BCO Shares Remain Remarkably Cheap

Down approximately 25% since our initial recommendation, our call on BCO has not been anything to brag about.  We think the company is on the cusp of a powerful earnings recovery as cash in transit volumes improve, diamond transaction volume accelerates, and Compusafe gains further traction. In addition, BCO has taken steps over the past 12-months to dramatically increase its presence in BRIC nations. We think these moves will extend BCO’s secular growth opportunities over the next ten years. After today’s rally, BCO shares now trade at 3.8x and 13.3x our EBITDA and EPS estimates for FY11; the stock has a free cash flow yield of more than 11%. BCO still has a powerful secular growth story as it continues to benefit from the global increase in cash in circulation and an increase in the installed base of ATM’s.  From a technical perspective it appears the stock has “broken out” from its three month down trend.  We think shares can trade into the low to mid 30-’s over the next 6-9 months based on a 17-18x multiple on our FY11 EPS estimate of $1.74.

As always, please act accordingly….