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Executives

Linda Segre - Senior Vice President - Corporate Strategy and Human Resources

Brian Driscoll - President and Chief Executive Officer

Michael Murphy - Interim Chief Financial Officer, Managing Director at Alix Partners

Mark Hair - Senior Vice President of Finance and Controller

Andrew Burke - Chief Marketing Officer, Executive Vice President

Analysts

Tim Ramey - D.A. Davidson

Akshay Jagdale - KeyBanc Capital Markets

Sarah Miller - SunTrust Robinson Humphrey

Tyler Reid - Jefferies

Brett Hunley - BB&T Capital Markets

Kenneth Zaslow - Bank of Montreal

Andrew Lazar - Barclays Capital

Diamond Foods, Inc. (DMND) F1Q 2013 Earnings Call December 17, 2012 5:00 PM ET

Operator

Good day, and welcome to the Diamond Foods earnings call. Today's conference is being recorded. At this time, I would like to turn the conference over to Linda Segre. Please go ahead.

Linda Segre

Thank you, Stephanie. Good afternoon and welcome to the Diamond Foods investor conference call and webcast to review our financial results for the first quarter of fiscal 2013 and the fourth quarter and full year of fiscal year 2012.

On today’s call are President and CEO, Brian Driscoll and Interim CFO, Mike Murphy of Alix Partners. In addition, Mark Hair, our Senior Vice President of Finance and Controller and Andrew Burke, our Chief Marketing Officer, will be available for Q&A at the end of our prepared remarks.

Before we begin, please remember that during the course of this call we will make forward-looking statements within the meaning of the federal securities laws. These forward-looking statements involve risks and uncertainties regarding the operations and future results of Diamond Foods.

In addition to the company’s periodic, current and annual reports filed with the Securities and Exchange Commission, please refer to the text of our press release for a discussion of the risks associated with such forward-looking statements.

Finally, please note that on today's call we will refer to certain non-GAAP financial measures in which we exclude from our GAAP financial results certain items including consulting, acquisition and integration, audit committee investigation and restatement related expenses.

We will also refer to adjusted EBITDA on today’s call. For a calculation of this measure, please refer to our press release. We believe these non-GAAP measures will provide useful information for investors. Please refer to today’s press release for a reconciliation of the non-GAAP performance measures to the GAAP financial results.

Now, I would like to turn the call over to Brian Driscoll, our President and Chief Executive Officer.

Brian Driscoll

Thank you, Linda, and good afternoon, everyone. Since our last call on November 14, I am happy to report that we are now current with our financial reporting and, as you may know, our upcoming shareholder meeting is planned for January 14, 2013. Our finance and accounting team has worked exceptionally hard to get us to this point and I thank them for their effort and dedication.

As you saw in our fiscal 2012 10-K filed on December 7, the financial results were in line with the information we provided on our November call. Our fourth quarter results were consistent with the trends we saw in the first three quarters of the fiscal year. Overall, fiscal 2012 was a difficult and challenging year.

As a reminder, on our call four weeks ago, I spoke about the inherent strengths and advantages of our brand portfolio and the opportunity to achieve a more sustainable growth profile over time. I also commented on the challenges we face in fiscal '13 which require comprehensive and aggressive measures. Our margin profile has substantial room for improvement; we are highly leveraged; we have walnut supply challenges, issues with our Emerald brand, and cost structure pressures.

As I mentioned then, we have launched a wide ranging set of initiatives designed to tackle these issues, which include refocusing on sustainable brand growth driven by innovation and differentiated advantage, repositioning the Emerald brand on more premium, competitively insulated items, optimizing our cost structure and operational effectiveness, evaluating options to address the leverage on our balance sheet and rebuilding walnut supply.

Turning to the first quarter of fiscal 2013, our financial results reflect some progress against key initiatives despite significant headwinds created by the decline in walnut supply. The year-over-year improvement in gross margin as a percentage of sales, for instance, can be tied back, in part, to our focus on net price realization and SKU rationalization. As well, we were able to begin adjusting our Stockton cost profile to align with reduced volume.

Importantly, let me remind you, we are planning to reduce our reliance on discounting over time and should, therefore, see reductions in subsidized market share and improvement in net price realization. For example, you can see in our Nielsen results in All Outlet Channels for the most recent 12 week scanning period, that overall scanned retail sales for Emerald and Kettle have declined.

However, these brands experienced growth of approximately 30% and 8%, respectively, in non-promoted sales. So thus far, we feel we’re taking these brands in the right direction. Additionally, if we are able to gain traction on our cost reduction efforts, we plan to reinvest in our brands in a targeted manner in the remainder of the year.

Our financial results for the first quarter also indicate an improvement in adjusted EBITDA margin as a percentage of sales as compared to last year. Our improvement in gross margin percentage certainly contributed to this expansion. However the decline in advertising expense was also a significant driver of increased EBITDA this quarter. The year-over-year decline in ad spending represents a shift in the timing of advertising expenditure rather than a structural reduction in our ad budget.

Consistent with our plan to invest in brand equity building activities, we have recently launched digital and print campaigns for Diamond of California, Pop Secret and Kettle. So expect ad spend to be at higher levels in the rest of the year. As such, our first quarter EBITDA margin may be higher than for the full year.

We have also been investing in adding key resources to our category business teams and innovation group in order to gain sharper focus on our brands and fill the pipeline with innovative products. It is worth mentioning that I have had the opportunity to review a few of the early ideas coming out of our innovation group and I am encouraged by what I am seeing.

Since we just held a call a few weeks ago, I don’t want to be redundant and repeat all the actions we are taking. For those of you who missed that call, you can find those remarks on our investor relations page on our website. While it is still early days, I feel that the company is making good progress on our initiatives and working hard to counter the drag on our financial results from the decline in walnut volume.

To help us address this issue, I am pleased that we recently hired Dave Colo into a newly created role of Executive Vice President of Global Operations and Supply Chain. Dave has run very complex operations at both ConAgra and Nestle and has significant experience in cost reduction, productivity and operational effectiveness.

On our last call, I described briefly our comprehensive efforts to reduce our cost structure and improve our executional capability. I mentioned that the sourcing initiative alone surfaced a potential $20 million of annualized cost savings. We have also identified potential savings in our manufacturing facilities of similar order of magnitude, and Dave has the requisite experience to lead the implementation of these initiatives to help us secure these savings.

Now I will turn it over to Mike Murphy to review our financial results. Mike?

Michael Murphy

Thanks, Brian. I want to first comment on our full year fiscal 2012 results, which we filed 10 days ago. The final numbers were consistent with the guidance we provided on our November 14 call.

Net sales were $981.4 million and snack sales were $605.8 million, both slightly above the ranges we provided. Our gross margin percentage for the year was 18.3%, which was in the guidance range of the 18% to 18.5%. We finished the year with adjusted EBITDA of $79.4 million, which was consistent with the $78 million to $81 million range we provided.

For the first quarter of fiscal 2013, financial performance showed some positive signs from our planned shift in strategy, particularly a decline in promotional spending. As Brian mentioned, the shift in the timing of advertising also had a significant impact on our operating results in the quarter. With that in mind, I will provide you some context for the numbers we released today.

Net sales totaled $258.5 million in the first quarter compared to $287.4 million in the same period last year. The decline is primarily due to a 58% drop in non-retail sales which were $13.7 million compared to $32.2 million last year. Culinary and domestic inshell sales declined 7.5% to $90.7 million compared to $98.1 million last year.

Snack sales were down 2% to $154.1 million for the quarter. This was primarily driven by declines in Emerald and to a lesser extent, Kettle, due to changes we made in promotional spending. Offsetting these declines somewhat, were strong Pop Secret sales in the quarter. Gross margin increased to 22.7% for the first quarter of 2013 compared to 21.3% for the prior year period due to margin expansion in our snack brands.

SG&A increased significantly in the first quarter to $38.2 million compared to $29.5 million last year. When adjusted for certain costs associated with legal, accounting, consulting, retention, severance, and other costs totaling $11.8 million, adjusted SG&A was $26.4 million or 10.2% of sales compared to an adjusted SG&A of $27.5 million or 9.57% of sales in the prior year period.

The Oaktree warrants are accounted for as derivative liabilities and therefore are re-measured at fair value every reporting period. In the first quarter, the company recognized a $7.5 million loss on the warrants, largely due to an increase in our stock price between July 31 and October 31 of this year.

EBIT margin for the first quarter, adjusted for certain costs provided in our press release, was 8.9% of net sales as compared to 8% in the prior year period. The expansion was due to both the improvement in gross margin and the reduction in advertising this quarter compared to the prior year period. This decline in ad spending represents a shift in timing rather than a sustained reduction through the rest of the year.

Interest expense in the first quarter was $13.9 million compared to $5.8 million in the prior year period. The increase is due primarily to higher interest rates on the Oaktree debt and to a lesser extent on our bank credit facility.

I also want to clarify our interest expense balances. As part of the recapitalization of our balance sheet, we incurred various third party fees, which were capitalized pursuant to GAAP. A portion of these fees were allocated to the Oaktree warrants and were expensed in the fourth quarter of fiscal 2012.

In addition, the Forbearance and Third Amendment were considered debt modifications to our bank facility, and as such, certain additional fees were expensed in the third and fourth quarters of fiscal 2012. On an ongoing basis, the remaining capitalized fees will be amortized on a straight line basis based on the remaining terms of the relevant debt facilities.

The effective tax rate for the first quarter on a GAAP basis was negative 6.1%. On a non-GAAP basis the effective tax rate was 36.6%, which reflects a change in the way we account for non-GAAP taxes which was implemented in the beginning of fiscal 2012.

The company had a net loss on a GAAP basis of $10.7 million for the first quarter of fiscal 2013 compared to net income of $10.8 million in the prior year period. Adjusted net income on a non-GAAP basis was $5.2 million compared to $16.3 million in the prior year. Net loss per share on a GAAP basis was $0.49 per share and earnings per share on a non-GAAP basis was $0.24 per share.

On a non-GAAP basis, EBITDA for the first quarter, adjusted for certain costs outlined in our press release, was $31 million or 12.0% of net sales compared to $29.8 million or 10.4% the prior year. CapEx in the quarter totaled $2.9 million.

Our net debt, on a GAAP basis as of October 31, was $596.9 million. As Brian mentioned in his remarks, we are continuing to evaluate options to address our highly leveraged balance sheet. With respect to our liquidity position, as of December 14, 2012 our cash and availability on our bank revolver was approximately $95 million.

With that, we will open the call now for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) We will take our first question from…

Tim Ramey - D.A. Davidson

It's Tim Ramey from D.A. Davidson. Disappointed that you don’t appear to be offering guidance. There is just so many moving pieces. Mike, you and I had a conversation about tax rate. We discussed it. You said taxes would be near zero and maybe you were referring to GAAP and I was referring to adjusted but it would be so helpful with all of these moving pieces, if you could at least see your way clear to a few rough around pieces of guidance. Have you given thought to that?

Michael Murphy

Yes, we have. I think I agree with you on the point about the moving pieces. In addition to that, you also have a lot of initiatives that the company has underway. I think we said last time its something we are going to evaluate. We also said last time we are probably going to go to a different the disclosure in terms of segments. That’s something we have to evaluate as well. So as these items get traction, we have got more visibility into them. It's something that the company is going to consider.

Tim Ramey - D.A. Davidson

Okay, but nothing in the near to medium term or likely for fiscal '13?

Brian Driscoll

Hi Tim, it's Brian. I am not sure that I would necessarily say that but we do need to give ourselves some time to determine what kind of traction we get behind these initiatives which are substantial for us. Until such time as we have a better recognition of that we don’t feel comfortable yet providing guidance.

Tim Ramey - D.A. Davidson

Well, let me just ask maybe in another way. You and I had a conversation where we discussed the meaning of the work transition and the conclusion was that transition 2013 was deemed a transition year. The last call meant that that was perhaps not the end result you would ultimately wanted to get to but it wasn’t the bottom. You were somewhere on the way to an earnings recovery. Would you still characterize 2013 as a transition given that definition?

Michael Murphy

Tim, its Mike Murphy. In my view, yes. I think with the initiatives underway just in terms of pulling out the promotional spending, a focus on this net price realization, stabilizing the walnut business, evaluating the company's debt structure on a go forward basis after it got in compliance, getting to the normalized basis for SG&A in terms of eliminating a lot of these one-time costs from the restatement, the investigation, everything else on top of that. Again, I think we talked about that last time event through this investor process we ran which resulted the Oaktree transaction. That was confirmed to us as well. It has got '13 really this transitional year for the company.

Tim Ramey - D.A. Davidson

Okay, and then, one other thing that we also discussed, which was when to put the dilution in for the warrants and it seemed like you had made a determination of that on the last call. Therefore I was estimating shares on a fully diluted basis including the warrants but that doesn’t appear to be the case. If the warrants are issued, those will be on the share count for the entire year. Is that right?

Mark Hair

So this is Mark Hair. To respond to that question is, in our financials, they aren’t shown because of the net loss position but we are aware of those warrants and they do. They will accounted for either when they are exercised or when we are not in that same position.

Tim Ramey - D.A. Davidson

Well, but your adjusted earnings is not a loss and you gave us a share count for adjusted earnings that didn’t include the warrants. I wonder why.

Mark Hair

We just didn’t make any adjustments to the GAAP disclosures in our 10-Q.

Operator

Thank you. Our next question comes from Bill Chappell.

Akshay Jagdale - KeyBanc Capital Markets

Hi, this is Akshay Jagdale from KeyBanc. I wanted to make sure it was my time. So, the first question is regarding the walnut business. Can you just help us understand where we are given your filings and the timing of it? As far as I know, you should have procured most of your walnuts for this year, if not all of them, by now. From what I know, market pricing is roughly flat year-over-year which is probably higher than what people were expecting six months ago.

Again, from what I know, you are still making an estimate in the first quarter. So in your inventory evaluation, you should have made an estimate on that walnut cost. So can you just help me understand, just to make sure that I understand this correctly. So do I have all those assumptions right?

Second, where are we in terms of volumes? Have you stabilized the business, meaning volumes are not declining anymore? It would be useful if you could give us a sense of where you are relative to that 125 million pound target that was set by Oaktree?

Mark Hair

Hi. Akshay. You are right in terms of we have received all of our walnuts for this year, in this fiscal year. Again, that all comes through in the October, November time frame. All those walnuts have received. They came in as we expected them to come in, leading up to the season. You are right in terms of your discussion regarding where walnut pricing is.

I would say, it would stay firm with last year. I think the things to consider there, as you know, this is a fluid market that we keep a good eye on. So industry shipments are ahead of last year and as you know the initial estimate of supply from the cast estimates in September was a reduction versus expectation.

So that was down to about 470,000 ton basis. There is a handler reported number. So there has been some discussions about potentially supplies a little larger than what that original cast estimate is. So we will have to keep an eye on that as we go through the finish of the selling season. So that’s an overview of supply.

In terms of where we are with our walnut partners, two days after we got off the last call we went out and saw hundreds of growers up and down the valley. Brian and Mike and myself and our grower relations team talking about Diamond and our plan going forward. We continue to work on those relationships to the secure those for future cropiers.

Brian Driscoll

This is Brian. We also had, just late last week, our grower advisory board meeting and feel good about the fact that we are getting the appropriate level of insight to contribute towards our goal to increase our crop supply going forward.

Akshay Jagdale - KeyBanc Capital Markets

Just as a follow up, so have the volumes stabilized? Meaning, you have been on a declining slope, didn’t meet your target. Have they at least stabilized?

Mark Hair

You are correct. As we had discussed on the last call, we didn’t meet the special redemption target of 125 million. We did get enough supply this year to support more than the retail channel.

In terms of, it's hard, I am not sure I follow you in terms about stabilizing. We talked about building backup. So we think we, for this last year's deliveries, we started that. We are right at to it again in trying to look at ways to accelerate some of that going into next year's deliveries cycle. So we are not waiting till the end to get visibility to that.

Akshay Jagdale - KeyBanc Capital Markets

Okay, and then just one more on the balance sheet. When you say evaluating options, I am assuming you are looking at the high-yield market. So if that is correct, what's the biggest impediment to accessing the public markets right now in your opinion now that your filings are out of the way and you are current?

Michael Murphy

This thing to address would be the fact that 2013 is that transition year for the company. There is a lot to present in terms of where the company has provided stability on a brand-by-brand basis. It has been going through more effective trade analysis as well. So its really, we go through that process of '13 projections of where we think we are going to be for 2014 when we talked to the credit markets about that.

Operator

Our next question comes from Bill Chappell.

Sarah Miller - SunTrust Robinson Humphrey

Hi, this is Sarah Miller, on for Bill. I have a question just kind of a quick follow-up on Akshay's. In terms of going forward, would you be able to say, was this quarter kind of a normalized quarter for the walnut business or is there another shoe to drop in terms of revenue and profitability before you can come back out of it?

Michael Murphy

This is Mike Murphy here. I wouldn’t say there is another shoe to drop. One thing we talked about, you see in this quarter because that’s when we get up to the first indication of the non-retail channel just being year-over-year just not have the implication of not having the right amount of volume for the walnuts. But in terms of expectation of price and how the company's taken price or setting price in that retail channel all that is effective there and you see the result of that.

But I am not aware of anything in terms of another shoe. I think what we are talking about is rebuilding that business and starting to rebuild to get more visibility in the volume for the next year. But at the same time, the company is already taking all these actions to move its cost structure down based on the volume of good visibility coming into this cycle.

Sarah Miller - SunTrust Robinson Humphrey

So do you see this October quarter as kind of a normalized performance for 2013 for the walnut business?

Andrew Burke

Again, the walnut business is a cyclical business. As you move through the year, certainly do more business up in the first quarter traditionally because of the season and the way that sells. So, again, like Mike said, given the lower volumes, we are prioritizing the customers and the outlets with which we sell that material to make sure we will get the highest return and the best long-term benefit for the company. That’s what we will stay focused on. So that’s what we will be doing throughout the year as we move through the year.

Operator

Our next question comes from Tyler Reid.

Tyler Reid - Jefferies

I have a quick question on the gross margin for you. Compared to the fourth quarter, your mix shift was much less in favor of snacks. Fourth quarter, you had a gross margin decline. Now you had a gross margin improvement. You talked about having reduced some promotions, but can you give us a little bit more detail on what the moving parts behind the gross margin were? What I mean is behind that prices, mix shifts, promotions and so on?

Mark Hair

I think you have got to break it a little bit down by the brands when you think of what Andrew just talked about in terms of the walnut business. Let's get the walnuts in to the right retail channel with margin. Let's get them in to the non-retail. So it’s a focus of right margin on that side. If you think it in across the other brands Kettle, Pop Secret, Emerald. Let's get down to start to see the first exercise of net price realization. So that’s on a SKU by SKU basis. So for Emerald is focused on those SKUs where grower margin where trades have been effective on that as well.

Tyler Reid - Jefferies

Given the revenue decline for the snack business, is the gross margin improvement for snacks or were you offsetting that volume decline? Is the gross profit for snacks actually growing right now?

Mark Hair

I am not sure I follow your question. So you are talking about the decline just in revenue that we plan forward, we are reducing SKUs on Emerald and others?

Tyler Reid - Jefferies

So Emerald and Kettle revenues are declining at least in scanner data. Yet you are taking out the lower profitable SKUs out. So what I am wondering is, is the revenue decline offset by higher average margins for the products that you are still selling and is there for the gross profit dollars for snacks? Are those actually growing right now.

Brian Driscoll

Tyler, we don’t breakout gross profit down in to those segments. But I think your overall thought is right, in terms of, as we eliminate inefficient discounting at the top line, we are also adjusting our cost base to pull cost out in line with those volume reductions. Then, as we said, begin more of the equity building pieces and getting back to the more added value parts to Emerald's business. So you will see that happen as we continue with those strategies going forward.

Tyler Reid - Jefferies

Okay, so the last question I had for you, you had talked about that you won't meet the Oaktree volume trigger. Do you right now expect to meet the gross margin trigger from the Oaktree agreement?

Brian Driscoll

It's both items. So if we are not going to meet the volume you are not going to gross margin. So we are not going to meet the special redemption provision.

Operator

We will take our next question from Heather Jones.

Brett Hunley - BB&T Capital Markets

This is Brett Hunley standing if for Heather. Not to beat this dead horse further but back to gross margin. So it sounds like, Brian, you talked about early on a number of structural issues or structural things that you see in place that can continue to improve gross margins but I am just curious if the walnut crop itself had a positive impact on the quarter?

There can be timing issues with the walnut crop and how that affects gross margin. I am just curious if there was anything that occurred from a crop standpoint that positively affects gross margin in Q1 that maybe wouldn’t carry in the Q2?

Brian Driscoll

In terms of crop year for walnuts, last year we talked about, it was a very late crop. This year it was shaping up to be a better crop. Then we had a little bit of a stall in terms of deliveries with the later varieties that came in. So we don’t expect to see big changes across quarters like we did in previous years, in terms of crops.

Again it is still going to be weighted more to the first half. So we will have to keep that in mind. The other thing to keep in mind is, we had taken some pricing that we are wrapping around as we move into this year. So you will have to keep an eye on that and what that affect is on our retail business is something we will keep in mind as we then look for the rest of the year.

Brett Hunley - BB&T Capital Markets

Okay and ad spending. We expect that to be flat year-over-year, at least that sounds like?

Brian Driscoll

I think the way to think about ad offending, and again we are not providing any guidance but I think the way to think about ad spending, as we have talked about on the previous call as well as this call we have reduced the amount of inefficient discounting and we are committed to investing in equity inspired spending. So you should expect to see more of that moving forward.

Brett Hunley - BB&T Capital Markets

Are you willing, I will drop it, but are you willing to talk about what the benefit was during the quarter from ad spending getting pushed out?

Michael Murphy

You can see from our quarter how much our ad spending is down versus last year. But, as Brian mentioned in his remarks and then Mike mentioned in his remarks, that is a timing event that happened last year that we pushed to the back of the year.

Brett Hunley - BB&T Capital Markets

Then just one last question. I just wanted to get a further update on Emerald. The Nielsen numbers through November, the performance was a little bit softer than what we estimate Emerald did year-over-year in Q1. Obviously we are working with our own assumptions there but i.e., I am just curious if you saw any acceleration in that softness in November? Or is it just that we are witnessing the early stages of the rationalization process here?

Michael Murphy

I think they way you summed it up at the end there is right. As we have discussed we are more aggressively dialing back the inefficient discounting for Emerald. So you are going to see that volume come off at a higher rate than some of our other brands as we then focus around our added value items like 100 Calorie Packs, like sweet and salty, like Cocoa Roast where we have added value and those will sustain a premium price and will be less elastic as we look to the back.

So that’s where we are focused. Again, in terms of expectations when we look at the business and what we see as Brian talked about in terms of our non-promoted growth. We are happy to see that play out the way it's playing out. We are going to continue to moderate as we move through the year.

Operator

We will take our next question from Ken Zaslow.

Kenneth Zaslow - Bank of Montreal

Couple of questions. One of them is, how much capacity have you guys have with walnut business?

Michael Murphy

Ask that again.

Brian Driscoll

How much capacity have you taken out?

Kenneth Zaslow - Bank of Montreal

How much have you taken out of your walnut business and how much do you plan on? I am assuming if it was originally five and probably less than that, I am assuming 125 was the right size. My guess is you probably took out 20% to 30% capacity, maybe in the 30%, 40%? I don’t know. I am just trying to figure out how much capacity do you guys actually got to do through the balance via supply and demand side.

Brian Driscoll

Ken, again, we haven’t released any specifics about what volume we did last year or this year. Again, we did say we didn’t get to the Oaktree redemption of 125 million. I think we are overall pleased at the way the cost reduction has gone as we have reduce costs in our Stockton facility and the Fishers announcement that we talked about last time.

Andrew Burke

The plant has the capacity to convert roughly 300 million pounds of walnuts of nuts and as you know we did less than 125 million pounds. That should inform you in terms of our capacity utilization. We have not worked towards fundamentally reducing the capacity capability of the plant but managing the actual capacity better to what the actual crop receipts are.

We are trying to create a capability that allows us to flex a plant up to the extent that we get more crop or manage it such that to the extent that we don’t, we do the best that we can to manage the margin structure.

Michael Murphy

The other the other part of that is obviously the reason, it made a lot of sense to consolidate the Fishers facility into Stockton. So in essence, all the Emerald production comes under the Stockton facility as well.

Kenneth Zaslow - Bank of Montreal

I guess what I am trying to get at is do you assume like in 2014 that your volumes will be higher? Will you be able to get growers back?

Michael Murphy

Certainly it is one of the challenges we face, as I mentioned earlier, is our walnut supply. Our goal of course is to increase the level of crop receipt we get significantly. That certainly is our goal. Which is why almost immediately after we had the last call we went out throughout the valley and met with hundreds of growers to essentially talk more specifically about our position and where we are and what our plans are going forward.

I would argue that we seem to be making some progress vis-à-vis how we are going about these relationships and how we are attempting to close this gap but we still don’t know and won't know in the immediate term.

Kenneth Zaslow - Bank of Montreal

On the Kettle side, you just broadly said, look we are, I think the commentary was, we are making some progress. What progress are you making with Kettle? In our idea, we are not seeing it. So we are just trying to figure out, is it more profitable? Where are you seeing the progress in Kettle?

Michael Murphy

So in terms of kettle, again, the two things to realize about the current data that you are looking at in IRR and Nielsen is the fact that you have a large merchandising program last year that we elected not to repeat this year. Then again the reduction that Brian talked about in terms of getting out of inefficient discounting which again would drive more baseline business in the quarter of plus 8% number in terms of most recent 12 weeks at the end of November number where we are seeing our baseline business do well. That’s good business for us.

In terms of progress, the other thing that Brian mentioned was the innovation group. Kettle is a brand that we think has just a terrific potential to expand out. In our last call we talked about the natural channel and the growth in the natural channel in terms of savory snacks, outside of potato chips. We think that is a great area for us to focus on and so the innovation team will be spending a lot of time focused on that area.

It does take some time for those ideas to come to life. But, again when you have a brand with the equity like Kettle it's certainly a place that we will focus on.

Kenneth Zaslow - Bank of Montreal

My last question is, in terms of, you are not ready to talk about quarterly distribution but maybe (inaudible), advertising will increase or commercial activity will increase in the back half of the year more than this year. Walnuts are going to slow down in terms of size of crop and historically the back half is lees smaller than the first half. Is it not logical to conclude that this first quarter is probably the highest EPS quarter throughout the year or there is something I am missing that would offset this?

Michael Murphy

There is only just the one thing that I will go back to you on there, Ken. You said promotional activity. I think you meant advertising activity in terms of the back of the year. So, yes we have some things in front of us. But again, we talked the last call about the amount of expense reduction programs that we have set up. Certainly the things that we do in terms of SKU reduction and volume reduction of inefficient volume. We have yet to see how that plays out.

Operator

We will take our next from Andrew Lazar.

Andrew Lazar - Barclays Capital

Just two things, I guess. First off, and I think you touched a little bit on this. Is all of the net pricing or I guess, more accurately the reduction in ineffective promotional spend already in place for the snacks business? Or is there more to come? Brands such as: Kettle and Emerald have been fairly sensitive to that. Are we some of the market share numbers that you put out there in the release. Where are you in the process and trying to get a sense if our expectations should be that that gets worse perhaps before it becomes a bigger benefit to margins?

Brian Driscoll

I think there is more to come. I think time will tell what the top line invocation will be of all. As you know, it’s a delicate process. That price realization is achieved in a number of different ways. Not the least of which is either the list price increases or trade reductions or weight ups and weight outs. There is variety of different approaches to be taken to achieve it. We are trying to strike that sweet spot where we get what we think is the most appropriate degree of realization for the brand.

So I think it is safe to say that more realization will occur throughout the fiscal year. The shape it takes will vary.

Andrew Lazar - Barclays Capital

Got it. Has the sensitivity, I know it’s a learning processes as you go through this process, but has the sensitivity to some of these moves on the core snack brands been more or less in keeping with what you had anticipated? Or is it really tough to know at the end of the day when you started this exactly how sensitive it would be?

Brian Driscoll

I think it's to say on a couple of businesses. I think on Emerald, it's harder to say. I think on the others, it is pretty much striking where we thought it would keep in mind that on Kettle, to a large extent, it is what we are cycling as much as what where we are doing in terms of net price realization.

So, as I said, on Emerald time will tell and we are looking at it quite closely. On the others, we believe that we are tracking pretty much where we thought we would. But again, keeping a careful eye on it.

Andrew Lazar - Barclays Capital

That’s helpful, thanks. Then last thing, I guess a bit broader thought process and maybe its sort of naïve one of the goals that you talked about here is obviously to try and increase your walnuts up pretty dramatically. As you mentioned, you have got enough supply for your demands on the higher-margin retail side of the businesses. Is that right?

Brian Driscoll

Yes, actually above that.

Andrew Lazar - Barclays Capital

Above that, exactly.

Brian Driscoll

But certainly sufficient to satisfy the branded business.

Andrew Lazar - Barclays Capital

So I am trying to get a sense of how much then of the non-retail business do you necessarily want, going forward? In other words, you are going after that business because you have the ability to process more and the capacity to do so and make some money on that? Or is it maybe less of a willingness to say, you know what, maybe a big part of business that we were in before, just because we have the capacity to do it, maybe it does not make sense to be going forward. How willing are you to shape the go forward nature of this business to be more focused on the higher-margin retail side versus where you were in a previous time period? Again, I may be naïve. I am just trying to get a sense of how you think about that.

Brian Driscoll

Actually, I don’t think that is naïve at all. Obviously the non-retail business, to the extent that we participate does serve as a good vehicle for solid cash flow but first and foremost our priority is our branded business and to tell you the truth, to the extent that we get more inventory we can exploit that franchise more so than we have been able to over the past number of years.

There are segments that were not participating in that we believe walnuts can and should participate in that we will have a much better opportunity to exploit if we had better definition around what our supply could be. I think walnuts can play more in snacks than certainly we are today. I think we can do more even on the culinary side than we are today, to the extent that we can get more supplies. So I do think clearly that to the extent that we can accelerate our progress along these lines that the profile of it can be quite attractive.

Operator

Our next question comes from Akshay Jagdale.

Akshay Jagdale - KeyBanc Capital Markets

Thanks for taking this follow-up. So just wanted to follow-up on gross margins. I know you have talked about them a lot but I am still not clear whether sequentially gross margins, so its taken advertising out of this, are going to be stable and improving. From where I sit, I am thinking in a cost of walnuts are flat. So that is not a change. Promotions are coming down and you want to do more in terms of reducing promotions if that increases margin. So I think that would fall in the positive on the margin side. When I read your 10-K I saw a tremendous amount of cost take out especially in the number of people working at the firm is down, I think 25% which I was surprised by. You have close two or three facilities. So help me understand the gross margin on a percentage basis sequentially. Is this a good base to start off? I think it is but correct me if I am wrong.

Michael Murphy

I think it would be a good day. There are variables to that though are a couple. Reductions that we are looking at and the future reductions of SKUs at the Emerald side, how quickly they match to that. But we were chasing SKUs at good margins. So that’s where we are building the whole business around. So the only issue is when those normalize for that purpose. But you do see some of the implications of that in this first quarter.

The other part on the walnut. You talked about walnut being stable year-over-year. I agree with you there. The only thing we have to watch is, as there is more information that comes out in the market where we see prices selling. Everybody has that issue but the company has good visibility to it. Good coordination with the growers. A lot of input on this grower advisory board. So I agree with you in the general sense.

Akshay Jagdale - KeyBanc Capital Markets

Okay, and another one. There is obviously a lot of uncertainty and I know at this point you are not willing to give guidance which makes it hard for anyone who is thinking of investing in your company. But you just put out your proxy. I am sure you have gone through a new compensation plan. So can you help us. At least give us a sense of how much stock is playing a role in the employees compensation now compared to before so that we get some level of understanding as to what you guys think of your stock price there?

Michael Murphy

I think I don’t know the exact number. I would have to get back to you. But I think I would look at this way. From my perspective, it is a lot tighter direction in terms of the company's plan to bonuses. Stock is a part of that but it's also a lot of execution. We are trying to also incentivize a measure to this execution of all these, the new initiatives underway as well.

Akshay Jagdale - KeyBanc Capital Markets

Okay, and just one last one, I guess on Emerald. Brain, you talked about a major initiative, right? Repositioning the Emerald brand. So clearly the market share numbers are coming down and I am just trying to understand at one point this was supposed to be a $300 million brand maybe earning mid-teens EBIT margins. Now obviously the sales numbers is probably going to be a lot lower but can you help us understand when you say there is tremendous margin potential and you talk about Emerald as being the one where there is most variability, can Emerald still earn a mid-teens EBIT margin? Or that’s still to be seen?

Michael Murphy

Again, we are not going to comment on an individual brands financial profile other than to say that if you recall on the last call I mentioned that the financial contribution that were getting from Emerald is not healthy and not positive. So the steps we are taking are designed to provide a profile that is in keeping with the profile were trying to achieve for the company overall. The focus is to get to a core that we believe are insulating insomuch as it would be difficult for competition to replicate the offerings and therefore can be priced at a level that of course would continue to be appealing to consumers and achieve a reasonable margin for us.

That plan and that ambition is still in its infancy. But as I mentioned earlier we are beginning to see signs of traction and are hopeful that that traction will accelerate in the coming months. Time will tell.

Operator

Our next question comes from Tim Ramey.

Tim Ramey - D.A. Davidson

Just as a follow-up. It seems like there, if you think about the jobs that you have to do this year, you got to rebuild confidence in growers, you have got to rebuild confidence in the investment community and in perhaps the credit markets most importantly. You really didn’t do a lot of that on this call, I have to say. What did you tell the growers when you went out and talk to 200 of them? Maybe there is something we are missing in that message.

Brian Driscoll

Well, a lot what we talked about his transparency. The fact that we intend to be competitive and then we emphasize the fact our execution around this year's crop was amongst the best we have had in terms of servicing their requirements. Frankly, overall, we got a very good reaction from our growers in terms of our candor, our desire and committed to the business going forward and our plans. So that was actually very positive sessions.

Michael Murphy

Tim, this is Mike Murphy. From the growers, first the company has been doing ever since the announcement that there was to be a restatement. So that one, by that time, the company put out a more very direct walnut costing policy, the growers have seen the implications of that and how they were paid for last year's crop. Then a lot of meets with the growers throughout this process when the company was under still trying to get his restatement out there. So they built the credibility. We have walked them through what the implications of the restatement mean and do not meet. They understand where the company is headed and more visibility with the next year's crop.

They also understand themselves about the importance of the walnut business to them and Diamond, as Diamond has got the signature brands out there. That supports price for everybody.

Tim Ramey - D.A. Davidson

No, you can't talk to 200 people and assume that’s a non-public conversation. So, assuming all those comments are public, maybe you would share some of them with us. What are the things that you told them that gave them confidence that you have perhaps haven’t said on this call?

Brian Driscoll

A lot of we have said in our last call to you guys as well as this call. So I will just go through from my list some of those that resonate in terms of the company's running its business on a go forward basis on this category business teams. So there is not, each brand is being managed and measured. Walnut business is one of those. We are going to sell those nuts. The more volume we get, there is a lot more margin the company to throw off of those. We have to even continue to play in the non- retail channel.

That’s an important consideration for them. The fact that we do have a set policy how we view our view of the market that resonates within. They have seen indications that are ready. That resonates with them as well. The fact that those meetings we were talking to them about how the company is are focused on walnut and rebuilding but also they understand the company could have done a lot better for 2012 if it had the right supply in place, would have helped as well.

So I think those are the type of things, where the feedback was across-the-board and even on the one-on-ones, strong, consistent message. We get it. That’s where you guys got a head. We understand what you have done and you have built the credibility for that.

Operator

At this time there are no further questions. I will now turn the call back over to Ms. Segre to make any additional or closing remarks.

Linda Segre

Thank you, Stephanie. Thank you for joining us. This will conclude our call.

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