On Oct. 31, I wrote an article about Diamond Foods (DMND). After yesterday's call with management, one may think that Diamond was more of a trick than a treat. However, in my last article I did warn that anyone who was considering investing in DMND would have to stomach the potential downside. In this article, I will give investors an overview of the important points that have thus far been released by management.
Management recognized that there have been three areas of weakness over the last year: "control environment, walnut grower, accounting, and accounts payable timing recognition." The Audit Committee has restated the results of FY 2011 and FY 2012 for DMND after the scandal that shocked the company. The Committee is still working on FY 2012, but has released the first three quarters as of yesterday, which will be discussed more below. EBITDA for 2010 came in at $68.2 million vs. $84.9 million originally, and EBITDA for 2011 came in at $111.5 million vs. $146.2 million originally. Another interesting tidbit was that the Committee found no evidence of fraud by former management. It had to restate and repay approximately $61.5 million in 2011 and $20.8 million in 2010 for walnut payments.
Nuts and Walnut Industry
There were two major takeaways from management's comments regarding the industry. First, the industry natural savory snacks segment has been growing at 20%. That is huge considering the slow nature of the food industry. Second was the low walnut supply in the year, which led to material results in the financial statements. Another interesting part was the comments regarding the Planters brand. Planters was intended to be under Mondelez (MDLZ), but was given to former parent Kraft Foods Group (KRFT) in the end. Planters is the No. 1 brand in nuts and has a 9% operating margin business. This provides DMND investors a relative idea of where the nuts segment of DMND could end up.
Value of the Brands (Pop Secret, Kettle, Emerald, and Diamond of California)
The main point of my last article on DMND was that the brands that DMND owns are worth more than the share price currently being given to it. The current intraday stock price on Nov. 15, 2012, is $15.50, or a $4 drop from the close on Nov. 14 (-20.5%). Did the market not realize that the results for the company were going to be impacted by restructuring and restatement costs, and that there would have to be margin contraction given that the company was previously underpaying suppliers?
One can clearly see that DMND has four real brands: Pop Secret, Kettle, Emerald, and Diamond of California (its main business). Pop Secret, Kettle, and Emerald are all brands that could be by themselves. The company reports its segments based on Total Retail and Total Non-Retail. Total Retail has its Snack and Culinary subsegments, and Total Non-Retail has International and North American Ingredient.
Pop Secret was the "standout performer" so far in 2012's first three quarters for the company. It grew market share 2.2% against 2011. Kettle is DMND's best hope for the future. It has potential for top-line growth and margin expansion according to management. Its former strategy to accelerate growth and mainstream penetration was inefficient. Kettle also has the benefit of being the first non-GMO potato chip, which could drive growth given the increase in food-conscious consumers. Management has cut back on promotional spending for Kettle, but its non-promoted sales grew 14.9% and gained 50 basis points of market share. Emerald is supposed to be the jewel of DMND's nuts business (pun intended). New management has gone with the strategy of making it a more efficient segment by cutting over 170 SKUs. These 170 SKUs represented 20% of revenue, but 65% of all SKUs. This is simple to do and makes sense looking at it from either the "80/20" rule or Pareto-type of system.
Management decided to close the Fishers, Ind., plant in order to boost efficiency given the overcapacity it currently has. This segment was poor for DMND over the last year as retail sales have declined. Diamond of California, what DMND is founded on, is "the clear branded leader in the culinary segment" with double the share of its next branded competitor. However, due to industry issues, DMND was forced to increase prices to offset rising costs and thus give up market share to private labels. The crop deliveries that fell significantly over the last year "had the greatest negative impact on overall financial results for the first three quarters of fiscal 2012." Management does not expect to rebuild the supply immediately nor will it reach the volume threshold needed to trigger the Oak Tree redemption feature.
The valuation range of the brands I mentioned in my previous article still hold as there is not enough information on the brands themselves at this point. My base case assumed 0% growth and the same multiples as when purchased still apply today. (Note: Kettle One's multiple is based on the Pringles sale multiple of 1.8.) My bear case assumes sales for each segment have dropped 5% in each segment and that the multiple used is only 75% of the base case multiple. My bull case assumes sales for each segment have increased 5% in each segment and that the multiple used is 125% of the base case multiple. Here are my calculations below:
Why would anyone want to invest in this stomach-churning company? Here are some reasons why you should consider such a name:
- Historically, the most beaten-down companies outperform other companies over a five-year span.
- Management has a set of initiatives in place with the focus on cost reduction, capacity rationalization, and improved price realization.
- The potential margin expansion in its brands and sustainable top-line growth profile will lead to increasing earnings. Management has a $20 million projection in annual cost savings, with opportunities to reduce costs in operations and its supply chain over the next two to three years.
- If the market can realize the value of the brands, watch out.
- There is the possibility of a buyout (discussed below).
The risks for DMND are clearly visible and innumerable, from an accounting mess that it may not recover from to simple business risks associated with its operations. The clear risk takeaways from the earnings call was that it is highly leveraged and has walnut supply challenges, specifically with Emerald.
Management provided some insight into the first three quarters of 2012 and what the company will probably finish at for the year. The first three quarters had net sales of $757 million, a 3.5% increase from 2011. This was driven by snack sales increasing 10% due to Emerald and Pop Secret, and Culinary sales increasing 11% due to a 12.2% increase in prices and 1.2% decline in volume year over year. However, International non-retail sales were weak as they plunged 47.7% year over year. The reason for the drastic decline was the walnut supply issue and increased costs per pound of walnut. WalnutMan, a frequent commenter on DMND articles on Seeking Alpha, has outlined in previous articles that DMND was going to face an increase in these costs (please reference any of the past DMND articles as he is a frequent contributor to these discussions). Capex was $40.6 million so far in 2012, but is expected to be much lower over the next one to one-and-a-half years.
One-time costs during the year were $16.6 million in restatement-related costs, which were included in SG&A, and a $40.6 million charge for Pringles-associated costs. This all resulted in EPS of $0.53 for FY 2012's first three months. In 2011, EPS was $1.54, showing a significant decline due to these one-time costs. Gross margins fell ~500 basis points to 18.1% due to the drop in deliveries and higher costs. This should have been obvious to the market as it was understood that DMND was underpaying suppliers and the lack of a walnut crop this year should increase the costs. The effective tax rate was a negative 3.3%, which will not be able to continue into the future if DMND turns around.
Other comments by management included the cost of debt for the company being ~6.75% and that they have not reached based earnings yet. Base earnings are expected to be in 2013, which management marked as a "turnaround year." With the lower-than-expected capex and the company still not at its turnaround year, there is potential doubt for the company as a going concern.
Management did highlight some expectations for the full FY 2012. It expects sales in the narrow range of $975 million to $980 million for the year, with Snack sales representing $600-$605 million and Culinary representing $290-$295 million. Gross margins are expected to be 18% to 18.5%, with EBITDA in the range of $78 million to $81 million.
Buyout Seems Likely by Oak Tree
One of the first comments on the call was that the executives, "have been evaluating where we believe our greatest opportunities for future growth and shareholder value exist." Given the financial weakness of the company and the still potential for growth with its valuable brands, it seems more likely that DMND could be taken private. Before the Oak Tree buy-in on May 29, 2012, rumors were flying that the company was going to be taken private. The Oak Tree $225 million debt is callable in May 2013, and management also commented that they are, "already evaluating what our alternative is that we have in terms of the right capital structure with that May call date in mind."
Why not a buyout of the company? The executive team in place comes from other companies that have been bought out before. Oak Tree has warrants to purchase 4.4 million shares of DMND stock with maturities in 2020 with 12% interest per year and an exercisable price of $10/share. If this were to take place, Oak Tree would own 16.4% of DMND. The agreement also stipulates that DMND must secure a specified minimum supply of walnuts from the 2012 crop to achieve profitability targets prior to Jan. 31, 2013. Management already commented that they would not make these levels in time. This will result in all of the warrants being cancelled and the option by Oak Tree to exchange $75 million of the senior notes for convertible preferred stock with a 10% dividend. To acquire more than a 15% stake in the company, the board would have to approve it given the shareholder plan in the 10-K. The board has already granted this to Oak Tree.
DMND has much debt and obligations coming due in the near future, as shown below in the excerpt from the July 31, 2011, restated 10-K.
Contractual Obligations and Commitments
Contractual obligations and commitments as of July 31, 2011, were as follows (in millions):
Payments Due by Period
Revolving line of credit
Interest on long-term obligations (A)
Purchase commitments (B)
Long-term deferred tax liabilities (C)
Other long-term liabilities (D)
On Oct. 31, 2013, covenants will apply to the bank debt that was initially $475 million. Initially the covenants are at levels of 4.70 to 1.00 for senior leverage ratio, declining over four quarters to 3.25 to 1.00 for the quarter ending July 2014, and then 2.00 to 1.00 for the fixed charge coverage ratio for each fiscal quarter (source: 10-Q). Another new covenant is that DMND must have at least $20 million in cash and equivalents beginning February 2013.
If one were to remove the unordinary items and look at earnings from continued operations, you would get the following (source: Capital IQ):
|Year||2012 (Apr. 30, 12)||Jul-31-2011||Jul-31-2010||Jul-31-2009|
|Cost Of Goods Sold||770.4||714.8||519.2||435.3|
|Selling General & Admin Exp.||164.0||141.4||97.3||89.8|
|Other Operating Exp., Total||164.0||141.4||97.3||89.8|
|Other Non-Operating Inc. (Exp.)||-||-||(1.8)||(0.9)|
|EBT Excl. Unusual Items||31.3||85.9||51.7||38.6|
|Income Tax Expense||8.3||18.9||14.0||14.9|
|Earnings from Cont. Ops.||23.0||67.0||37.7||23.7|
|Weighted Avg. Diluted Shares Out.||21.7||22.2||19.3||16.7|
As shown, DMND would really have EPS of $1.06 after removing unordinary items. The market currently thinks EPS is only $0.53. This sets up DMND for a potential rebound once the unordinary items are excluded moving forward. (Note: Shares outstanding did change so it does affect my previous shares outstanding for the values of the brands. However, many variables are not known and if anything, the lower share count raises the values of the brands.)
Overall, the future for DMND looks bleak but with promise on the horizon. It will be a difficult year ahead, but the value for shareholders truly relies on the brands that it owns. The best bet for current shareholders now would be for Oak Tree to buy out the company in the hopes of spinning it off in its own IPO down the road. Oak Tree's business as a P/E firm is centered on doing things like this. It logically makes sense for them to buy out the company, leave management in place, and oversee the restructuring of the company in hopes of potential multiple expansion and earnings growth down the road. It could spell big profits for Oak Tree long term. With interest rates being so low, this deal for Oak Tree can easily be financed.