I like to search for recently distressed stocks that have strong brands coupled with a core business operation that generates lots of cash, but whose value has been hidden. Diamond Foods (DMND) fits that description. In a recent article about Diamond Foods on SA, author Jim Fish enumerated all of the reasons why not to own Diamond, and the list is extensive. Going long on a distressed stock with recent accounting improprieties, negative tangible book value and very low cash reserves is not for the faint of heart. In the case of Diamond Foods though, behind that tattered walnut shell is a very profitable snack business that is driving significant free cash flow which has been obfuscated by the recent accounting mess. Diamond is significantly undervalued from both a sum of parts analysis by Mr. Fish, and from a free cash flow perspective described here - both of which will eventually lead to a higher stock price for Diamond either through investors coming back to the stock, or a buyout from a competitor. This presents us with an intriguing risk/reward turnaround opportunity.
Figure 1: Diamond Foods Adjusted Free Cash Flow since start of FY11 ($M) totals $66.4M
With the coming close of Diamond's FY13 second quarter on January 31, the accounting investigation expenses will be behind them and the fog that has been hanging over their financial statements and stock for the past two years will lift. Since the beginning of FY11 (last nine quarters), Diamond has recorded $104.5M of one-time expenses due to its failed acquisition of Pringles ($61.7M) and the investigation into its accounting of walnut payment timing ($42.8M). Removing those non-recurring charges from Diamond's free cash flow over that period uncovers that on-going operations generated $66.4M of adjusted free cash flow (see Figure 1), included $15.7M last quarter (6% of revenue). This free cash flow was generated in spite of the following significant headwinds:
- Walnut growers payment disputes, supply issues and increased costs
- High interest payments on the debt required to cover the cost of the investigation ($13.9M/Q)
- Entrance and ramp up of a new senior management team during a crisis
- Intense distraction of the failed Pringles acquisition
While Diamond's Non-Retail segment revenue is down 67% from its peak due to the issues with walnut growers, its retail segment has remained strong and had its second all-time best quarter in Q1 (Figure 2) driven by its very strong snack brands (Emerald, Kettle and Pop Secret) which now represent 68% of its retail business over the past four quarters. With the end of the non-recurring cash expenses in Q2, the free cash flow generated from on-going operations will permit an increase in advertising for the snacks business that will facilitate a return to double digit growth in the segment. This last point is critical, as snack market share going forward is the largest concern from the Q1 conference call. The stock will bounce back quickly once snack growth shines again.
Figure 2: Diamond Foods Revenue by Segment ($K)
The Free Cash Flow Case
With the removal of one-time expenses, Diamond has already generated $1.40 in free cash flow over the past four quarters. With a reasonable trailing Price-to-FCF ratio of 12, that already places fair value at $21 versus a price today of approximately $14. If we extend that to FY13, with a modest 1% overall increase in FY13 revenues over FY12 and an FY13 average gross margin of 21%, Diamond can generate about $2.25 of free cash flow (~ $51M) during FY13. Remember that they already generated $15.7M in FY13 Q1. Applying that same Price-to-FCF ratio of 12, that would suggest a target of about $35, or a potential for 150% upside.
For those attracted to the large potential upside of a turnaround, Diamond Foods presents an interesting opportunity as most of the risks are behind them and ongoing operations are generating significant cash flows. While it could take several quarters for the stock to "pop" up, downside appears to be limited as expectations are extremely low. I have recently taken a long position in DMND.