Investors in Diamond Foods (DMND) have been experiencing gut-wrenching news and updates over the last year. On December 17, 2012, DMND released its Q1 FY13 results. Analysts would probably label this call as "weak," "disappointing" and "frustrating." Investors need only look at Tim Ramey's (D.A Davidson) comments toward the end of the earnings call:
"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 talked to 200 of them?"
Executive Michael Murphy brushed aside what Ramey was trying to get at and didn't really answer what Ramey was looking for. Ramey even went on to say:
"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."
Executive Brian Driscoll tried to further appease Ramey but did not give any more clarity. Quickly after Brian's answer, the Ooperator on the call told listeners the call was over, leaving investors and analysts frustrated. On December 18, 2012, Ramey did lower his price target of DMND from $30 to $20 but this still represents upside of ~40%.
Rather than get into all the details that many other authors, including myself, have dived into over the last year, here are the reasons investors should not own DMND:
- The accounting scandal overhang and after-effects as a result. Prior management had shifted costs of walnuts to different time periods to reflect stronger profit and cash flow. This became apparent when DMND claimed to be paying a "momentum" payment to growers prior to the Pringles deal.
- Lawsuits by shareholders due to massive losses (shares used to be above $90). These lawsuits are a result of the poor management and accounting scandal.
- The current management regime took a long-time to restate the financials, leading to an almost delisting from the exchange.
- DMND has not hosted an Investor Day yet
- $596.9M in debt still remains on its balance sheet due to former CEO Mendes' "growth by acquisition" strategy. Much of this debt is due to the acquisition of Kettle Brands.
- Opportunity cost of the loss of Pringles brand, as Pringles in recent quarters has been a huge driver of growth for the Kellogg Company (K). In fact, in the most recent quarter from K, Pringles had North American organic sales growth of 10%.
- No longer has a dividend
- High cost of capital
- Walnut supply challenges
- Issues with Emerald brand
- Declining gross profit margin
- Management expects market share reductions due to less promotional spending and less SKUs
- Negative earnings
- Rebuilding/transition year for FY13
- DMND did not meet the Oak Tree Capital warrant levels. This can have a dilutive impact on DMND earnings, and management did not even include the warrants in adjusted earnings in Q1's results.
- The lack of transparency by management, as it is not disclosing the brands' results and not offering guidance. This creates distrust with management.
As one can see, there are plenty of reasons to not own DMND. There are other plays in this sector that are way less risky than shares of DMND and create value for shareholders. However, there are reasons to speculate on this company. The risk/reward opportunity is enormous if management can complete a turnaround. The following are reasons for investors to consider owning DMND:
- Value can be had if a turnaround can be completed by management
- Current management has experience with selling a company to private equity firms and other larger public companies, leading some to wonder if DMND will either sell off brands or the entire company. This would lead to share prices increasing.
- Improvement in net price realization
- Targeting $20M in annual cost savings, due to synergies, lower advertising, lower SKUs, and the closing of the Fishers, Indiana plant.
- Plenty of capacity remains online, as the plants can manage 300M pounds of walnuts. To give investors an idea, DMND is currently handling less than 125M pounds, meaning it is only operating at 1/3 capacity.
- Gross profit margin improvement is possible.
- Walnut supply is continuing to back to normal conditions. DMND will need to get back to the share of this supply that they once had to increase their dominance in that space. This comes with creating trust with growers, as DMND used to be a coalition of California walnut growers but evolved away from that.
- There are many one-time or temporary charges in the current results, leading to large differences between GAAP and Non-GAAP values. Once the bleeding stops for DMND, it can get back to being a normal food manufacturer. This can lead to a reduction in debt and less overhang with the company.
- The recent hiring of Dave Colo for its President of Global Operations and Supply Chain is a good sign. DMND is bringing in an experienced professional who has improved the operations of two of the largest food manufacturers in the world, namely, ConAgra Foods (CAG) and Nestle (NSRGY.PK).
- The quote by Executive Michael Murphy: "I wouldn't say there is another shoe to drop." This could be interpreted to mean that everything negative is already out there for investors.
- Shares sold short have been north of 35% for sometime. Eventually, this becomes dead-money for those selling it short or the possibility of improving numbers could chase them out. If this were to happen, shares would increase rapidly.
- The most important reason to own DMND is the value of the brands in its Snacks segment. It owns Emerald, Kettle and Pop Secret. In Q1 FY13, Emerald and Kettle were experiencing declines due to lower promotional spending and lower SKUs. However, Pop Secret remains strong. The Snacks segment had a 22.7% gross profit margin in Q1, which is up 140 bps from Q1 of FY12. Sales were down 2% in Q1 FY13 but still accounted for 59.6% of total net sales. This company thus is no longer a walnut company but a snack company as more sales come from the Snacks segment of brands it acquired over the last 5 years than the original purpose of selling walnuts.
Due to the lack of transparency, it is hard to value the brands as the sales and operating profits are not known. The only thing that is known is that sales have been weak, with the exception of Pop Secret. In my previous analysis, I tried figuring out the revenue for each brand. Due to the lack of transparency, to do this would be assuming too many variables. If one were to use the FY12 values and forecast out the Snacks and Nuts (non-snacks/non-retail) Segment, it is conceivable to get the range below for FY13:
The multiples for the Snack segment were based on the median EV/Revenue multiple for DMND (Base case), and two standard deviations away from the median. This gives a 95% confidence interval. The Non-Snacks segment multiples were based on the EV/Revenue multiple prior to the acquisitions, and plus or minus two standard deviations. The Shares Outstanding amount takes the diluted shares outstanding that was reported and adds back in the convertible warrants of Oak Tree. This leads to a combined valuation of the two segments of:
Even on a bear case-scenario, the company should trade above where it is currently. Looking deeper into this, the Snack segment on a Bear case alone makes up more than the current stock price. In other words, if DMND were to be acquired or spin-off the Snacks brands, they should at least be valued at $16/share. There is a current frenzy for the brands of Hostess Brands.
DMND is no longer about the nuts aspect of its business, but more so the three brands of the Snacks segment: Emerald (retail nuts), Kettle, and Pop Secret. The Snacks segment is generating stronger gross profit margins than the business as a whole and has brand recognition for all three brands within it. A few investment firms like Apollo Global Management (APO), Litespeed Management, and Oak Tree Capital have taken stakes in DMND. They aren't after the nuts business, but the Emerald, Kettle, and Pop Secret brands. Pop Secret was acquired for 1.9x EV/Revenue and Kettle for 2.6x EV/Revenue. The bull case scenario doesn't even take these steeper valuations into account.
The base case is not even taking into account multiple expansion given that companies like Kellogg, Pepsi-Co (Frito-Lay) and ConAgra (Orville Redenbacher) have much higher EV/Revenue multiples. These companies are much more than snack plays, but still have equitable brands to DMND's Snack segment. In other words, the market is not taking into account the value of DMND's Snack segment and is deeply discounting it. At worst, this company could sell off individual brands to reduce the debt load. This provides patient investors who are willing to put up with a volatile stock price a potential opportunity for strong potential long-term gains if the turnaround can be completed. That "if" is still a big "if" though.
Additional disclosure: I own 10 shares out of a pure 'interested in a turnaround' perspective only. It does not have a meaningful affect on my portfolio. Once I see some transparency and data that I see as evidence of a turnaround coming, I may initiate a stronger position in DMND.