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Diamond Foods, Inc. (NASDAQ:DMND)

F1Q09 Earnings Call

December 3, 2008 4:30 pm ET

Executives

Robert Philipps – VP IR

Michael Mendes – President & CEO

Gary Ford – COO

Steven Neil – CFO

Analysts

Heather Jones - BB&T Capital Markets

Diane Geissler - Merrill Lynch

Mark Argento – Craig-Hallum Capital Group

Kenneth Zaslow - BMO Capital Markets

Sarah Lester – Sidoti & Company

Operator

Good afternoon and welcome everyone to the Diamond Foods fiscal 2009 first quarter earnings conference call. (Operator Instructions) At this time I would now like to turn the call over to Mr. Robert Phillips.

Robert Philipps

Good afternoon everyone. Welcome to the Diamond Foods investor conference call and webcast to review the financial results of our fiscal 2009 first quarter which ended October 31, 2008.

Before we get started, let’s cover a few housekeeping items. First, a printed copy of our prepared remarks will be available on our website www.diamondfoods.com under the section titled Investor Relations followed by Earnings Releases within one hour after the call’s conclusion.

Second, we've arranged for a taped replay of this call to be available via telephone beginning about three hours after the call’s conclusion through midnight Eastern Time on December 8, 2008. The dial-in number to access the replay is 1-888-203-1112 from the US or Canada, or 719-457-0820 elsewhere, and a conference ID is 5429012. In addition, this call is being webcast live and a replay will be available on the website.

Third, we want to remind you that during the course of today’s call we will make forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995, including projections of our results.

Since actual results may differ materially from these projections, we encourage you to learn more about the risks and uncertainties that affect our business by reviewing our SEC filings under the heading Risk Factors.

Note that our forward-looking statements are based on factors that are subject to change and therefore these statements speak only as of the date they are given. We do not undertake to update forward-looking statements.

Now I'd like to turn the call over to Michael Mendes, President, and Chief Executive Officer of Diamond Foods

Michael Mendes

Thanks Robert, good afternoon everyone and thank you for joining us. On our call today will be Gary Ford, our Chief Operating Officer, and Steven Neil, our Chief Financial and Administrative Officer.

Diamond was founded in 1912 and has endured a number of difficult economic cycles over this period. During the last decade we have more then tripled the size of our company and have prospered by staying focused on two underlying principles; delivering compelling quality, service, and value to consumers and our trade partners, and maintaining a disciplined focus on executing against our strategy while demonstrating an exceptional ability to adapt to a rapidly changing environment.

By investing in our brands and continuing to increase our value proposition to our customers we will strengthen the foundation of our business in order to deliver sustainable earnings growth.

Based on our strong start to fiscal 2009, we are confident we can achieve this goal despite facing a difficult economic environment.

Let me take a few moments to address some of the highlights of the quarter. North American retail sales, the focus of our growth efforts, increased 23% for the quarter over last year and represented 77% of our sales mix.

As the walnut harvest was delayed by a week, in-shell and ingredient sales were lower then projected further increasing the shift towards higher margin retail sales.

And in addition our cost efficiency initiatives and continued leveraging of our infrastructure resulted in a significant increase in margins. Our gross margin was 21% for the quarter and our operating margin was 11%. Non-GAAP EPS grew 29% to $0.67 per share.

But the numbers only tell part of the story. Our strategy to broaden the distribution of core Emerald items and grocery is progressing and translating into meaningful velocity gains. This bodes well for the brands’ ability to grow profitably in the future and drive category expansion.

We acquired Pop Secret from General Mills on September 15. Consistent with our intent to reenergize the microwave popcorn category we launched a series of Pop Secret television commercials only 40 days following the acquisition.

We have already aired over 400 television ads nationally during October and November alone.

We continue to be committed to supporting our brands with marketing, product, and packaging innovation. Coupled with our unparalleled quality, service, and supply chain management, we are making significant strides in bolstering our position as a trusted supplier of our trade partners.

This can be illustrated in part by the performance of the Diamond brand which grew sales three times faster then the category securing a 100 basis point share gain over the last 12-week period.

Finally it is important to note that much of the capital raised during our 2005 IPO was initially allocated to projects that added capacity to support the growth of our retail business. Beginning last year we started to shift a larger portion of our capital investment towards efficiency projects designed to lower our unit cost in the future.

At this time, I’d like to turn the call over to Gary who will provide some additional insight on operating highlights for the quarter.

Gary Ford

Thanks Michael, our path to sustainable earnings growth has three key elements; growing our value added branded segment to improve the product mix and continue to rationalize low margin business, maintaining a disciplined focus on the channels in which we compete in order to leverage our existing infrastructure, and investing in capital projects that improve the cost efficiency of our business.

Let me start with a review of our snack business, our snack portfolio grew 96% during the quarter which reflected the mid-quarter acquisition of Pop Secret and over 20% growth from Emerald.

In grocery, Emerald’s ACV distribution improved 200 basis points to 88% and we continue to gain market share as additional shelf space is allocated to core items. In the mass merchandise channel, Breakfast on the Go has been expanded from two SKUs to three, and all three will be in nearly 3,000 stores early in the calendar year.

In the club channel Cocoa Roast Almonds is now a regular item in about 150 stores and will be in an additional 350 stores starting in February. Two of our newest items, Gourmet Snack Mix and 100 Calorie Pack Cocoa Roast Almonds, have begun shipping this month to a regional club store customer.

This is the first time Emerald has made inroads with this customer and our 100-Calorie Pack Snack Nuts, in particular target a segment of the category that is currently under served.

Finally Sea Salt & Pepper Cashews and the Gourmet Snack Mix are being tested in a number of club stores around the country.

Pop Secret is off to a good start for the 45 days we owned the brand this quarter. Grocery sales for October grew 7% and market share held steady at 24%. Note that we are in the very early stages of Pop Secret’s integration into our snack business.

There is a lot of work to be done. A key part of our integration plan was to take over sales and marketing responsibility day one, while relying on General Mills for transitional services in other areas including order to cash and supply chain services while working closely with customers to better understand their Pop Secret business and replenishment needs.

We believe this will facilitate a smoother transition of supply chain responsibilities when we complete the cut over in our third fiscal quarter.

Now let’s move to culinary nuts, our reputation for delivering service and quality is a key selling point for retailers looking to manage risk and assure reliability. As a result, culinary sales grew 23% and outpaced the category with walnut sales growing by more then 14% versus last year in grocery.

Now let me switch gears and talk about what we’re doing to improve operating efficiency. In last year’s first quarter we outsourced some of our rigid form club packaging until we began to develop this business.

Later in the year we brought this capability in-house and we’re now seeing the full benefit in lower unit cost this year as our club sales continues to grow. Looking ahead we’re working on a number of similar efficiency projects that will lower unit cost while we continue to leverage fixed costs and sales scale up.

When our Stockton, California plant was constructed in the late 1950s, it was designed to handle nut varieties which no longer are popular today. In fact the three most popular varieties of walnuts today weren’t even in existence back then.

We are initiating a material handling project that will optimize the processing of these new varieties. This multi year project will result in higher yields and throughput both of which drive down unit costs as well as produce better quality.

In our Fishers, Indiana plant we are preparing to invest in new roasting and packaging equipment to support our snack business and reduce transit times and costs to the East Coast.

Finally we are continuing to reduce fixed cost by rationalizing some of our remote handling facilities.

Now I’ll turn the call over to Steven.

Steven Neil

Thanks Gary, and good afternoon everyone. Please note that both the press release and 10-Q were filed today.

Let me start with a few comments about the quarter, the 21% gross margin in the quarter reflects our continuing product mix shift to higher margin retail sales as well as the actions we took last year to tightly manage our production costs to help cover higher input costs.

Since the walnut crop and the timing of Thanksgiving were a bit later this year then last, sales of lower margin in-shell and ingredient business will shift into the balance of the year reducing overall margins a bit.

SG&A expense was 8.1% of sales compared to 8.2% for full year fiscal 2008 and last year’s first quarter of 6.2%. This quarter’s numbers includes the amortization of intangibles, and incremental staffing and expenses associated with the Pop Secret acquisition.

The advertising expense increase in the quarter reflects the first flight of Pop Secret advertising and continuing investment in Diamond and Emerald brands. Interest expense was $1.5 million due primarily to borrowings supporting the purchase of Pop Secret.

At October 31, our debt outstanding was $206 million with a weighted average interest rate just over 5%. There were two non-recurring items recorded in other income and expense that had about a $0.03 per share adverse impact on EPS in the quarter.

As part of the Pop Secret acquisition we paid off our senior long-term notes and incurred a $2.6 million prepayment penalty which represented the present value of all future interest expense that would have been paid on the notes if we had held them to maturity.

Partially offsetting this was a $1.7 million gain on the sale of admission reduction credits that were primarily earned as a result of our closure of our [co-generation] power facility in 2005.

We booked an effective tax rate of 37.5% in the quarter. We continue to expect a full year effective tax rate of between 37% and 38% as discrete items per GAAP can only be recorded in the quarter they are realized.

As a result of our favorable sales mix and aggressive production cost control, profits beat the high end of our guidance. EPS for the quarter of $0.64 or $0.67 on a non-GAAP basis compared to $0.52 last year.

And finally we paid a $0.045 per share dividend on October 29. Now let me shift gears and review our financial expectations for full year fiscal 2009 which are consistent with that which we communicated last quarter.

We expect full year non-GAAP EPS to range from $1.20 to $1.27. GAAP EPS would be impacted by the $0.03 in net non-recurring charges from the debt prepayment penalty and the sale of ERC credits previously mentioned.

We expect net sales to be between $585 million and $615 million driven by North American retail sales growth of between 27% and 31%.

Included in this growth is an assumption that snack sales will be between $175 million and $185 million.

Gross margins for the year should improve 150 to 200 basis points as a result of efficiency initiatives that we are driving in the manufacturing and supply chain areas, the right-sizing of our low margin business, and of course the addition of Pop Secret.

Advertising expenses will range from $26 million to $29 million reflecting the investments we plan to make in Pop Secret as well as continued heavy support of Emerald and Diamond brands and cross-promotional activities.

Interest expenses which of course are influenced by the finance markets, are like to run between $9 million and $10 million reflecting higher levels of debt incurred from financing Pop Secret.

Capital expenditures will be between $10 million and $13 million in fiscal 2009 as we invest in informational technology improvements and equipment associated with manufacturing efficiency, new products, and capacity.

For the second quarter of fiscal 2009 we expect the top line to be between $140 million and $155 million compared to last year’s $133.8 million. EPS looks to be between $0.24 and $0.29 compared to $0.17 in last year’s quarter.

This means that first half fiscal 2009 EPS growth should be fairly close to what we expect for the full fiscal year.

At this time, we’d like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Heather Jones - BB&T Capital Markets

Heather Jones - BB&T Capital Markets

Just looking at your culinary segment here and it did very well, it was very strong relative to our estimate and year-over-year, and I was wondering if you wouldn’t mind putting a little color to that for me.

Michael Mendes

I think that there’s some macro trends that I think are favorable for us right now in that culinary segment. I think as people are looking for more in-home meal preparation our culinary line is very well positioned to capitalize in that trend.

Also we have a very well developed brand and we believe some very strong merchandising which we’ve been working on improving and I think that those are some of the trends that have helped support the business. But we are pleased with our performance in the quarter there.

Heather Jones - BB&T Capital Markets

As far as the walnut harvest coming in rather large, what do you anticipate for pricing at the retail level, do you see that maybe coming down along with the walnut crop?

Michael Mendes

As far as the walnut crop, the harvest is just winding up now. The actual state, final numbers get reported in January so at that time we’d have knowledge of the full crop size so it’s a little preliminary to make that estimate and then we’ll also have better knowledge of other tree nut crops that compete in the macroeconomic environment with walnuts.

I think that being said, I think that generally with tree nuts we’re seeing probably in the back half of the year, some price reductions reflecting the overall larger supply. I would say that the nature of the culinary and snack nut business, culinary in particular, the biggest demand and the biggest sales take place in the fall. Most of that product needs to be positioned in the supply chain in July and August in order to service that business.

So you wouldn’t see any impact of any commodity price adjustments probably until the second half of our fiscal year.

Heather Jones - BB&T Capital Markets

Just watching Pop Secret as well as your new products initially, is it too early to tell kind of what these items will do to your long-term sales growth goals as far as moving that range and then are you still comfortable with your accretion guidance for Pop Secret?

Michael Mendes

As far as our comfort on our single-digit accretion guidance, we’re very early into the integration but I would say that there is nothing that has happened to this date that we feel has materially affected our thinking from when we gave that guidance.

But we are going to be converting the, taking full control and completing the integration in February of next year so there is a lot of components that we’re needing to take on ourselves and General Mills is still in a transition services agreement for us.

So again we’re not, I think it’s a bit early to state with great confidence [inaudible] integration, but at this point in time we’re very pleased with the work we’ve done to date. As far as the overall range, it’s a bit early.

We’ve been very focused on the integration. We do know that if we want to grow in the microwave popcorn category we’re going to need to bring innovation in terms of product and packaging and so the first thing we did was start to invest in new product research and also investing money on consumer research to have a better understanding of consumers’ needs and desires.

So we’re still in the learning phase and we feel optimistic that we can bring some things to the category there but its again, pretty early in the game for us to speak without a lot of detail at this point in time. But we’ll try to give more color on that in our future calls.

Operator

Your next question comes from the line of Diane Geissler - Merrill Lynch

Diane Geissler - Merrill Lynch

Just wanted to ask on the, obviously you exceeded your target that you had set in late September for the quarter and I guess I’m just, but reiterating the guidance for the full year and if you could just help me understand, is there something in particular you’re looking at that says, okay we should remain cautious. Is it just you’ve only owned Pop Secret for six weeks, is it just that you haven’t owned Pop Secret long enough, or are you concerned about trade down in the retail channel that would keep you from moving your target range up at this time.

Michael Mendes

I think when you look at the first quarter and some of the comments we made earlier, one thing that we did benefit in the first quarter was having a higher proportion of our sales be represented by our retail sales because in part the walnut crop was later and also Thanksgiving was a bit later this year.

So as a result we did on our ingredient and international side the portion of sales in the quarter were lower then we would have projected because the crop was lower so the profitability of the quarter was higher and that the, that was ingredient international sales, they will shift to the last three quarters of the year.

So that’s one part of it. The second component of it is that obviously there’s a lot of volatility around input costs and as well as consumers pricing orientation and the channels which will excel. I think in context of that our guidance I think captures the puts and the takes that we see at this point being one quarter into the fiscal year.

And when you look at that we’re guiding 32% to 40% earnings growth for the year which is I think quite strong versus a lot of food companies in the United States we think that its prudent to hold pat here being less then a third of a way through the fiscal year.

Diane Geissler - Merrill Lynch

Can we just talk a little bit about the consumer, this is obviously something we’ve heard with a lot of the companies that have reported in this cycle about trade down, obviously snack nuts, a little more discretionary then some other items that you can find in the grocery store. What have you heard from retailers and what have you experienced at the shelf. It sounds like you’re continuing to get pretty good distribution of new products, whether it’s the mass or club or even within grocery, but can you talk about that a little bit, what you’ve seen this fall.

Michael Mendes

In the last three years where we saw commodity price acceleration in tree nuts, one way that we addressed this with our retail partners is we shifted more of our promotional spending towards smaller pack size items, [rescue-ready], single serve items, and we did not promote as intensely in the large frame items.

Moving forward what we are seeing now and what we are projecting forward is looking to pass a little more value in those large size packs. Some of that will flow just into by pack size, some of that will flow more into the channels as well that carry those large sizes.

So I think that that’s where you’ll see a more of a value being passed through to consumers as well as perhaps a little more of an increase in the frequency and the depth of our promotions.

Diane Geissler - Merrill Lynch

Just the comment on the expectation that we might see some deflation in pricing at retail because of lower commodity prices in the back half of the year, that actually, well deflation always is a little scary, it actually sounds good for you because one of the impediments for your product has always been the high price point. Do you see that as, if you can maintain your margin and pass that on to the end consumer wouldn’t you expect that there would be incremental volume off that relationship? In other words it’s an event you actually welcome because tree nut prices have just been so high.

Michael Mendes

That’s the very discussion we had yesterday, myself and some of the leadership team and I think that the thing we’ve noticed is that there are definite price points particularly in promotions where you can get multiple items at a certain price point that really trigger a significant volume increases and I do think that we maybe moving into a period that we may be able to achieve that and provide a better value for consumers versus other choice that they have.

And so yes, I definitely think that’s part of the opportunity and what we need to do is try to be very strategic and clever to make sure that we identify and understand those price points and those value opportunities and we try to work with our retail partners to provide those opportunities to the consumers versus just sort of bluntly spreading weakening pricing over a bunch of weeks of the year.

So I think that it does provide an opportunity for us and I think that we will see some volume increase in particular as a result of that.

Diane Geissler - Merrill Lynch

And just maybe to clarify your comment from before because based on our read of the IRI data, we haven’t seen a big, we haven’t seen that shift out of snack nuts. Maybe the volume is down a little bit but pricing is up significantly because of this factor on the raw input costs but the dollar sales seems to have been holding steady, is that your experience?

Michael Mendes

Yes, we are—

Diane Geissler - Merrill Lynch

The category itself seems to be holding in there and then of course you are either, I think the last period you showed us a slight decline but for the last 13 four-week periods the majority of them, you’ve shown you’ve outpaced the category. Is that your experience?

Michael Mendes

I think the thing that we’re encouraged about is the non-scan channels which are more of the value channels, we’re actually seeing stronger performance then in grocery. So if grocery represents maybe a third of all snack nut consumption goes at grocery channel, I think in the value channels your actually seeing an even stronger velocity because of their positioning in type of environment so I would say that the health benefit trends of health nuts, of nuts and also the convenience is a very good environmental benefit of these products relative to what consumers have to choose from and I think that we do very much benefit from the fact that in the last few years, more and more consumers really are understanding of the healthful benefits of fats that, of the dietary fats you can get from nut products and as a good source of protein and so we’re able to play in a much larger threshold of product choices then we might have historically.

So we definitely like the product range that we’re in and we feel good about this ability to hold a good mindshare and product share with the consumer.

Operator

Your next question comes from the line of Mark Argento – Craig-Hallum Capital Group

Mark Argento – Craig-Hallum Capital Group

I know with the dollar strengthening here over the last few months in particular could you talk a little bit about how you seen that impact your business in terms of buying trends?

Michael Mendes

I’m going to answer that a little more broad and then have Gary talk about this on the back end. As far as our sourcing, a major portion of our raw material sourcing are from parts of the United States. On the go to market side we do have an international business which we have been strategically rationalizing over the last few years in that we felt there was an opportunity to reduce our business risk by moving away from customers in some of our international markets who really were quite price-sensitive on the commodity front. That’s boded quite well for us in this current environment and so we’re pleased with that.

Gary Ford

We are definitely looking at some positive things from our input costs going forward in pretty much all commodities. From an international sales standpoint we were a little soft early because of the late crop. We’re now starting to see that pick up and from a price standpoint as we were record prices, record high prices last year, some of that has and with kind of the normalizing for lack of a better word, of some of the products we sell internationally, that’s kind of had an offset to the strengthening dollar.

Mark Argento – Craig-Hallum Capital Group

In terms of overall unit growth on the culinary side, what kind of unit growth are you experiencing. I know your experience in 20% plus top line or dollar share growth there, but what kind of unit growth are you experiencing there?

Michael Mendes

We don’t generally disclose that for competitive purposes but obviously with the price per ounce on a number of these tree crops being higher, there’s been a bit of a trade off on the volume. I would say on the net its been a favorable transaction but I do think that as we promote these products a bit more aggressively here this coming year, we will see a drive upward in volume and that coupled with greater availability.

I think one of the issues has been we’ve had a limited supply of tree nuts, of certain tree nuts at the back half of each year in the last three years, and I think that lack of availability did impact some, pursuing some sales opportunities.

The nice thing about a more abundant supply environment I think is going to allow us to just get after opportunities that we were somewhat supply constrained to pursue and so I think that we do have a significant opportunity to increase volume this coming year.

Mark Argento – Craig-Hallum Capital Group

What are you seeing from retailers, I know we’ve talked to some retailers and some other food companies, and clearly retailers are really pushing the manufacturers to bring down price or to get more aggressive on promotion, get the turns up on the shelves. Are you seeing that same type of behavior within the grocery aisle business?

Michael Mendes

Our mindset with our retailers is really a partnership orientation and our approach has been to hand and glove work with them to determine how we can bring greater value to the consumers. So we feel very aligned with the desire to try to bring value to the consumers particularly in this economic environment, we work with our retail partners.

So we’ve been quite aggressive in trying to find ways to drive volume for us and them with the way we’ve been preparing our promotional program for this coming year. On the consumer support side its another way we support our retail partners for our brand is to stimulate the consumers to buy the product.

We are significantly increasing our advertising this year as compared to last year not only on Diamond and Emerald, but also on Pop Secret compared to what we spent to get that brand in the last two or three years.

So I think when you look at the whole host of input investments we are turning up the volume in a way that brings more value for the consumers but also stimulates interest which generally I think is very closely aligned with our retail partners.

So our thought process is their challenge is valid and that as good partners we need to work with them together to try to bring that consumer value because we will all get rewarded with greater sales velocity in the future.

Mark Argento – Craig-Hallum Capital Group

I know the legacy being that of a co-op you have the relationship with the growers on the walnut side and you’re obligated to take the product, can you explain a little bit, just a high level, how you actually then price the product in terms of what you’re paying the growers relative to how that works itself through your P&L, meaning if you take all the product up front, you get to sell it through and then go back and then set the price. Can you just walk through how that works at a high level.

Michael Mendes

We have got a fantastic relationship with our walnut grower partners and there’s a lot of ways that we provide them value. The price for the raw materials is one part of it. One thing about many of our large walnut growers is that our ability to provide them outstanding service at the time of harvest is critical and their ability to provide an optimal quality product and if they can provide optimal quality product they can significantly impact their return per pound.

And that’s been a big part of our focus here in the early fall. Generally we have some visibility on our retail value of walnuts and some things we’re doing in the fall early on, but the back half of the year is very difficult to predict at this time of year.

And some of the things that we have to factor in is the contracts that we may book for the year and if there’s any risk of those contracts being executed. I think that one of the issues in a large supply year is there may be some risk of compliance with some of the customers in the more commodity-based part of the business.

Fortunately we’ve reduced our reliance on that. That’s still a volatility. And then there’s an estimated value of the raw material. We tend to try to set this price in March. We’ll need to project forward what that value is going to be of that unsold product.

So how much product we have sold at that time we’re setting the price makes it easier, there’s less of that product is sold at that time that makes that job a little bit more difficult. So there’s science and there’s a bit of art to it and the key is from our vantage point is to maximize value.

Our ability to maximize value, optimize our ability to increase that total return and so we do feel that we’re doing some things to optimize value that maybe our competitors can’t. One big part of that is cost efficiency and cost management and the final thing is that with a little larger supply we can perhaps have some more efficiency in our overhead utilization and so we’re working through a lot of those components.

There’s a lot to it and that’s some of the broad strokes.

Steven Neil

And I would say just from a pure GAAP cost perspective, we have to estimate what that cost is here in the first two quarters when we finalize it in the third quarter so we do our best estimate to project out to the year and obviously when you get into March it becomes solidified.

So it’s a little bit of an estimation here in the first two quarters as we work through that process.

Mark Argento – Craig-Hallum Capital Group

So if the crop, we’re seeing the [inaudible] suggesting a larger crop, one would assume that means pricing comes down a little bit. Is that how you go about estimating what your cost of goods are in the first two quarters?

Michael Mendes

That could be one component but if that’s what you used in the previous three years you would have been wrong.

Mark Argento – Craig-Hallum Capital Group

I guess maybe a different question for you is is your estimate flat, up or down that you’ve been using over the last couple of quarter, in your estimates as you say in Q1 and your reporting.

Steven Neil

Again we have to take a look at the whole macro environment so you can’t really draw a conclusion. A couple of years ago was a record crop and the costs went up so its pretty dynamic. You can’t focus on just one thing and we need to put all the components together in all the markets. So I think Michael was probably right, it’s a little bit more of an art perhaps then a science.

But usually we end up being reasonably close so you don’t see huge swings as we affirm the estimates up. I don’t know if we can get any more specific then that.

Mark Argento – Craig-Hallum Capital Group

I guess I’m just trying to understand the dynamic given the fact that you bring all your crop in and then you have to parse it out, you don’t really know what the price is. I guess I’m just trying to understand where, if prices are actually coming down on the input side, has that already been reflected in your Q1 numbers. That’s really the genesis of my question.

Michael Mendes

I would say that the margin gap I think, I think that the margin gap will hold but the actual top line component, there could be some variability on that.

Operator

Your next question comes from the line of Kenneth Zaslow - BMO Capital Markets

Kenneth Zaslow - BMO Capital Markets

Just one point of clarification, did you say to Diane’s question that you have less sales therefore you have higher profit? Is that, in the first quarter and therefore you’re going to have more sales in the back half of the year, therefore you’re going to have lower profits?

Michael Mendes

That the international ingredient sales that there were less in the first quarter correct, and there’ll be therefore more shifted into the back three quarters and that the margin on that business is lower then our retail business, that’s correct.

Kenneth Zaslow - BMO Capital Markets

But the actual dollars that you bring in, because maybe I’m just misunderstanding. The question was because you had a better quarter in the first quarter but your guidance for the back three quarters are kind of a little bit lower. Your full year is the same so but you had a better quarter because you had lower sales and higher profits but going back you’re going to have less sales and higher profits?

Steven Neil

No, let me say it a bit differently. In the first quarter our retail sales as a percentage of total sales were higher because the later walnut crop meaning less in-shell and less ingredient were in the first quarter then we would have estimated, however retail sales were present in the quarter. So we have 77% of the sales in this quarter were retail sales. If you look last year it was, retail was only 70%.

So higher margin retail sales were greater in the first quarter and then contrary in the balance of the year the ingredient and in-shell sales will be greater then what we had previously predicted.

Kenneth Zaslow - BMO Capital Markets

You don’t bring margins down to the EPS line, you bring dollars.

Steven Neil

Dollars, that’s correct but the margin could be different on the two channels, two different mixes of business.

Kenneth Zaslow - BMO Capital Markets

I totally agree with that it just seems to me that your dollars are still going to be less then what you would have expected and it doesn’t matter about the margin. I’ll take it offline. If I look at your sales growth for the snack nuts, you said I think it was up 20% plus, how did that break out between pricing and volume and particularly on the volume side, did you get more distribution, what was the benefit of the volume on those snack nut sales?

Michael Mendes

We did build out distribution on our core items. That’s one thing we’ve talked about on previous calls that we’re trying to build that distribution of core Emerald items and we had a nice increase in terms of our facings and us mapping versus the prior year quarter.

We had more distribution in those higher moving, higher velocity areas and then we also had the benefit of new distribution of items like Cocoa Roast Almonds and Sea Salt & Pepper in grocery as well as some new distribution of Breakfast on the Go in the mass merchant channel. I think those were some of the elements that were driving that.

Kenneth Zaslow - BMO Capital Markets

So the volume and pricing was relatively balanced?

Michael Mendes

I would say a little more price then volume perhaps but relatively balanced.

Kenneth Zaslow - BMO Capital Markets

But still getting a volume growth.

Michael Mendes

Yes, I would say that maybe the mix, just to kind of get your mind around it, is that tree nuts was up as part of the mix so really it was more possible a mix issue. We sort of improved the, part of our movement as we went away we have less volume against some of our less strategic peanut SKUs and we had more dollar volume against more strategic tree nut SKUs at our core items.

And that’s why the price is higher. Its not that just price increased or anything like that.

Kenneth Zaslow - BMO Capital Markets

How is the utilization, if you take us through the utilization rates from last year to this year to how you see it, can you tell us how that’s going to progress? I think you have enough utilization, you have enough capacity to build out I believe like 50% of it. Is there some sort of progression to which you’ll be building out your capacity. If you could update us on that.

Michael Mendes

I’m going to have Gary talk about it, in the script Gary did mention about a capital project that we have planned for our Indianapolis facility which is going to reduce costs and increase capacity. As far as our base snack operation in Stockton, we still do have capacity there particularly for the club segment, for the large frame items since we put the new [PET] line in.

Gary Ford

We definitely want to, as we’re in a high growth mode here we would definitely want to not be constrained with capacity so we’re going to invest a little bit in front of that and part of that is we’re going to do it not just in invest in capacity but we’re also, its an investment in cost reductions.

As we mentioned in the Fishers, Indiana, plant we’re going to be installing a state of the art oven with packaging capabilities and we’ll be doing that over the next several quarters and that’s not just going to add capacity.

As we look forward as to what we’re going to need, its also going to reduce our costs drastically from a, particularly from a miles-driven standpoint of both commodities coming in as we get peanuts and pecans and from the southeast, southwest, the US, running to California then running it back to the east coast is quite expensive.

So in addition to adding needed capacity that’s going to create a significant cost reduction for us as well. So we’re already in the engineering design stages of that project and we’re not going to put an exact date as to when we’re going to complete it yet because we’re still in the design stages but we’ll have it online before we need the capacity.

Kenneth Zaslow - BMO Capital Markets

So are you starting to fill up the capacity that you, are you almost up to the point where you’re going to need to get that extra capacity?

Michael Mendes

I think the question will be what’s our product mix this coming year. I think as we grow into the more premium tree nut items as we have up to this date the volume, the pound volume is lower. But we are a bit underdeveloped in the peanut subset of the snack nut category.

If we can make gains in that segment that would be more inline with our overall market share in tree nuts, that would go through capacity quite quickly and so we do have a vision for that and I think we are comfortably ahead of ourselves but we’re trying to be prudent.

Kenneth Zaslow - BMO Capital Markets

The macroeconomic environment and all that’s going on, that doesn’t change how you look at the future in terms of getting to your long-term numbers, I’m assuming that’s a softball question that just is a simple yes, right?

Michael Mendes

I think, ultimately I think that we need to be a student of this environment and ask ourselves how can a company like ourselves position ourselves to be successful two and three years out. We are very committed to that long-term sustainable profit growth and that means that in a year like this, we’re going to be evaluating all sorts of ways that this weakened economic environment can give us a chance to maybe create value in our assets that can be generated into earnings in future years and we will execute against that and that’s reflected in our guidance.

Kenneth Zaslow - BMO Capital Markets

I’m talking about beyond this year.

Michael Mendes

I’m just saying that this year and I think more of a question for you should be, what are you doing this year to get the returns next year. Well you’d better be investing this year and we are investing and we are not, and we are going to not compromise that earnings-generating engine by shorting our investments against our brands or our new distribution and our new products.

We are significantly increasing for example our investment in new product development right now and those are the things we’re going to need to do, versus me just saying yes, we’re going to hit the number. I think a better answer is, and here’s what we’re doing now in order to be a better company next year and two years from now.

And we’re very committed to that.

Kenneth Zaslow - BMO Capital Markets

So there is no reason to believe that your long-term outlook should change.

Michael Mendes

No.

Operator

Your final question comes from the line of Sarah Lester – Sidoti & Company

Sarah Lester – Sidoti & Company

On SG&A expense, I guess some of those costs from the Pop Secret acquisition, will any of that go away once the integration is complete and if so, is there any way you can quantify how much?

Steven Neil

Yes and no. You are right, most of the cost increases is associated with Pop Secret and let me give you a little bit more color on that. We did staff up ahead of the acquisition so that we would be in a position to start the integration from day one so there’s a little bit of a spending ahead of what you would say the revenue was for the quarter.

We are obviously once we get into the business we have the normal sales expense, broker expense, etc. so that’s why you’re seeing the dollars going up a bit. There is some cost that will go away. We have a transition services agreement as we’ve mentioned with General Mills so we are building our infrastructure i.e. spending the SG&A today as well as incurring some transition services expenses with General Mills.

As we convert in our third fiscal quarter the transition expenses with General Mills goes away and we just have our infrastructure. Its not a gigantic number by any means but certainly is, there’s multiple spending today that would be reduced a little bit as we get into the end of the third fiscal quarter.

Michael Mendes

There are some elements such as brokerage, where for the Pop Secret business most of the business resides in grocery which is a full brokerage environment and our average Diamond Foods business on average has a lower brokerage percentage then on average the Pop Secret business will have going forward. So that would be an example of where as a percentage of sales SG&A would be higher.

Take R&D, I would say that our R&D spend as a percentage of sales given the size of the Pop Secret business will be higher then proportionately our base business. But then hopefully we’ll pick up some efficiencies go forward. I think that that’s very important this year that we integrate this business in a very effective manner.

Our feeling is that a long integration costs more then a short integration and you don’t get any better output so we will be working hard to do it right the first time and again, in total we reflect that in our guidance but you will see that higher SG&A as a percentage reflect some of those elements.

Sarah Lester – Sidoti & Company

Did you break out how much of sales from Pop Secret this quarter?

Steven Neil

No we didn’t. Pop Secret is, because of the cross-promotional activities in the basically joined by the hip with Emerald we didn’t. So we’re just going to report the snack performance. We did indicate that the overall Emerald products were up over 20% in the quarter so you can kind of back into it but just because it gets so muddied as we cross promote it just doesn’t make good sense to do that.

So we’re not going to break it out.

Michael Mendes

And we did and will continue to share lead indicators such as market share.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Michael Mendes

Thank you. Before we conclude our call today, I just want to remind you of a few of our upcoming events. On the investor relation front we’re attending the Merrill Lynch Small Cap conference in Boston on December 10 and we have an Analyst Day scheduled for January 27 at the NASDAQ market site in New York.

This month we are sponsoring the Emerald Bowl on Saturday, December 27 which will be in San Francisco. This college bowl game is going to feature ACC and PAC 10 teams and that’s going to be aired nationally on ESPN.

We are also the sponsor of the Emerald Midnight Run which will be on December 31 in New York City. So we’d like to invite you to join us in Central Park for this annual event to ring in the New Year and take part in our healthy lifestyle run series.

If you need more information regarding our investor information or promotional events we encourage you to visit the Diamond website. Thank you for joining us on our call today and that will conclude our comments.

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Source: Diamond Foods, Inc. F1Q09 (Qtr End 10/31/08) Earnings Call Transcript
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