Diamond Foods (DMND) released results on March 11, 2013. Despite the uncertainty still surrounding the stock, Q2 results were very good. Here are some highlights from the call:
- CEO Driscoll: "Let me begin by saying that I am encouraged by the progress we are making with our turnaround efforts and the traction we're beginning to achieve against our key initiatives. This progress is evidenced in our second quarter financial performance. The improvements in gross profit, gross margin and EBITDA, achieved primarily as a result of improved net price realization and a focus on our cost-reduction initiatives, was coupled with targeted investment and brand-building activities."
- Shifting away from discount-driven growth across Snack segment and got rid of low-margin SKUs in Emerald brand. This led to a 690 bps expansion Y/Y.
- Nuts Segment had a 540 bps GPM expansion despite a volume drop of 30%. This comes from getting rid of lower margin-SKUs and the given principal of profit maximization. At a certain point, producing more goods leads to economic losses. Management is trending back towards the profit maximization point:
- $20-$40M in cost savings will occur over the next 18-24 months in manufacturing operations and in non-walnut procurement.
- Guidance for 2H of FY13: "we do expect consolidated sales in the back half of the fiscal year to be down more compared to prior year than we saw in the first half of this fiscal year, primarily due to the full effect of the Emerald SKU reduction, the reduced amount of walnuts available to sell, and the continuing emphasis on net price realization. Our consolidated gross margin has been fairly stable for the past 2 quarters, and we currently believe represents a reasonable estimate for the remainder of the year." As a reference, Q1 Y/Y was down 10%, Q2 was down 15.82%, thus leaving the 1H down 12.81%.
- Edward Aaron of RBC asked an important question about the 2-4% margin improvement from the cost savings. He inquired about the reinvestment possibilities in the company given the margin improvement, to which Driscoll said, "Yes. I would not consider the savings profile on a linear basis, as you associate it with margin. We're looking to reinvest a good percentage. I'm not prepared to be precise on that at this stage all those savings back into the brands, but importantly, back into high-traction activities… You invest in strong margin, high-traction activities. And then that just kind of -- that cycle kind of builds on itself over time"
- Kenneth Zaslow inquired about the turnaround in Emerald, to which management said that they heavy SKU reduction has been completed and that it should rebound come Q1 FY14 (less than 6 months away).
- DMND paid down ~$50M in debt and achieved a profitable quarter. Management increased visibility and transparency of the company by showing the different segments (Nuts and Snacks). The Nuts segment is comprised of Diamond and Emerald, and Snacks is comprised of Kettle and Pop Secret.
Margins are what is going to get DMND out of the mess it is in. It is overly leveraged due to the past issues with the company. In 2004, it launched the Emerald brand. The company did an IPO in 2005, followed by the acquisitions of Pop Secret in 2008 and Kettle in 2010. A key trend to watch in any turnaround story is the margin improvement. As evidenced by its GPM (and predicted in this article), DMND could be in the beginning of a turnaround. This is not Hostess Brands as previous management dealt with in the past. Hostess was dealing more with labor inputs than raw material inputs due to the high pension expenses and the union at the facility. GPM declined from its high back in Q4 of 2009 to its low of just over 15% in Q2 FY12. It has since rebounded due to management's strategy of cutting low-margin SKUs (namely in Emerald) and limiting discounts (Source: Capital IQ):
GPM is expected to continue to be roughly 23% in FY13 and potentially improve beyond that, despite higher potential walnut costs.
EBITDA Margin is another important metric to monitor for a turnaround as it shows the strength in the operations of the business. In FY12, EBITDA was meaningless. It had come down from ~16% in Q1 FY10 to under 2% in Q3 FY12. This was due to the higher costs in SG&A and cost of goods sold (COGS) (Source: Capital IQ):
The turnaround can be shown on a more granular level. Within Q2, margins have expanded since the 2012 lows. In fact, NPM was the highest it's been in the last 5 years (due to reduced taxes with NOLs and some benefits from the Oaktree warrants)! However, margins within Q2 improved back to what I described here as the normal level. (Source: Capital IQ):
In the past, Q2 accounted for a good deal of the fiscal year's revenue. This was due to the holiday season generating greater sales, especially in the walnuts category. Gross profit was relatively stable in Q2 at about 6% of the entire fiscal year's, with the exception of 2012 (Source: Capital IQ):
It would appear that FY12 was an odd year for DMND despite the headwinds moving forward. 2009-2011 appear to be the correct comparable years, as already evidenced by the return to margins in these years. With management forecasting margin to maintain its pace for this year and increase moving forward, DMND will experience higher operating cash flow. In FY13, DMND has had two positive quarters of cash flow from operations. If it can continue to become more efficient and spur off cash, it will be able to pay its debts down sooner (Source: Capital IQ):
DMND still has $552.56M outstanding of its debt. Most of this is from the Kettle acquisition in 2010 that carries a cost of debt of roughly 6.78%. However, due to the recent capital restructure, DMND's $225M debt outstanding to Oaktree carries a cost of debt of 12%. This is significant and not sustainable. Management's main goal is to pay down debt to get rid of the high interest payments and expand net profit margin. There are two options management really has and has alluded to: an equity offering or a spin-off. With 10.5M shares on the balance sheet as Treasury stock, management could recycle these shares back into the system. It appears likely that management will issue shares to pay off the Oaktree warrant. They will need to get the company on a firm footing before being able to do this, which is what they discussed on the call. The timing of the potential equity issuance is not known. If DMND issued 10M shares at $15/share, which it is allowed to do, it would raise $150M. It could then use this and FCF to pay down the $225M owed to Oaktree and lower its cost of capital. This would be dilutive to shareholders but worth it in the long-run. Another possibility that an investor would like to see is a spin-off of the Nuts segment to a PE firm. Although management would give up the Diamond and Emerald brands in this spin-off, it would be left with a better structured firm and two decent brands in Kettle and Pop Secret. These two brands support higher margins as well. However, DMND has actually a very good ttm cash conversion cycle due to the increase in days payable but has a dangerous Altman Z-Score (which shows bankruptcy potential) (Source: Capital IQ):
It also is dangerous when it comes to its current debt/capital and EBIT/Interest Expense which can show the danger of it now being able to pay its debts (Source: Capital IQ):
The hope though is that the cash flow generation that investors are seeing in the two most recent quarters, will continue. This will further allow the company to pay down debt without touching the markets. Its cost of equity is actually higher than its cost of debt given the higher risks associated with the stock.
Many readers of my articles will find a few articles on DMND. These articles did a sum-of-the-parts approach based on P/S. Given management's new and transparent guidance, it is easier to do a discounted cash flow approach for the business as a whole and on a sum-of-the-parts basis. I did three scenarios with four different models: a basic business DCF, a split DCF, an equity offer DCF, and an equity offer sum-of-the-parts DCF. For FY13, I used Y/Y 2H growth rates of -20%, -15%, and -10% for my Bear, Base, and Bull valuation. This leads to sales values of $824M, $846M, and $867M. As a reminder, management said that sales would be down further Y/Y in the 2H than in the 1H. The 1H had sales decline about 13%, but GPM did improve significantly. In FY13, a main assumption of mine is that Snacks and Nuts sales would be approximately equal as Snacks catches up to Nuts for the year. The 2H is typically less revenue and less gross profit than the 1H, thus the stronger decline is not as meaningful as a 1H decline. Q3 and Q4 sales are estimated at:
For the Bear case, Snacks and Nuts were grown at 3% Y/Y and 1% Y/Y, respectively, after FY13. Margins were kept relatively flat, with only ~1% difference in total margins from FY13-FY17. Snacks will become 52% of sales and generate 72.3% of gross profits. This will lead to NPM becoming 5%:
Management also has highlighted that they will not have a lot of capital investments in FY13. This is evidenced by the already low 1H capital investment of ~$4M. Using these assumptions, the following Bear case was obtained, as management spits off assets to generate cash flow:
I then applied the Bear case to a sum-of-the parts approach. Company-wide items (ex: D&A) was assumed to be allocated as a percentage of revenue (with the exception of interest expense). This brings up another issue. The parts were treated with the different cost of debts, as the Oaktree capital was meant for the Nuts business. This carries a cost of debt of 12% and debt for Nuts of an assumed $225M. The Snacks segment is thus left with ~$327.5M in debt but at a lower cost of debt:
Combining the two parts, leads to a valuation of $17.38 on a Bear case. Most of the FCF generated will come from the Snacks business in other words, with potential cash flow from the lowered Emerald SKUs.
However, the question arises about what if management does an equity offering of 10M shares? This would actually only hurt valuation a small amount (<$0.50). It would also change the capital structure such that the cost of equity would become more influential and create a higher cost of capital. It is assumed that all of the $150M generated (if priced at $15/share) would pay down part of the $225M in debt. On a business-whole approach, the following valuation occurs:
On a sum-of-the parts- equity offering basis, a valuation of $15.88 was obtained with $8.33 and $7.55 from Snacks and Nuts, respectively. The increase in Nuts value due to debt reduction was offset by the dilution of shares affecting the Snacks segment.
For the Base Case, Snacks and Nuts were grown at 5% and 3% Y/Y, respectively. Margins would increase by about 3% over the next 5 years (including SG&A costs). Given that management is forecasting about 2-4% in cost saving improvements ($20M-$40M), these estimates are not unreasonable. Snacks will become 52% of sales and generate 72% of the gross profits as well. The overall GPM by 2017 is forecasted to be 25.11%, leading to NPM of 6.3%:
Using these assumptions, the following Base case was obtained, with the same company-wide ideas generating cash flow as in the Bear case:
I then applied the Base case to a sum-of-the parts approach, using the same style as described in the Bear case:
Combining the two parts, leads to a valuation of $24.08 on a Base case. As one can see, the Snacks segment matters almost twice as much as the Nuts segment. The market is thinking only of the nuts businesses instead of the other two brands (Pop Secret and Kettle) in terms of generating growth.
With an equity offering of 10M shares and applying the same method as the Bear case equity would lead to a total business valuation of $17.32:
On a sum-of-the parts- equity offering basis, a valuation of $21.57 was obtained with $11.17 and $10.40 from Snacks and Nuts, respectively. The increase in Nuts value due to debt reduction was offset by the dilution of shares affecting the Snacks segment.
The Bull Case had Snacks and Nuts grow at 7% and 5% Y/Y, respectively. Margins would increase significantly as walnut suppliers would come back to DMND and there would be a good crop. GPMs for each segment would improve 4%. Snacks would become 52% of sales and generate 69.5% of gross profits. GPM for the entire company would improve 560 bps over the next 5 years as Nuts would become better for the company. The overall GPM by 2017 is forecasted to be 28.4%, with a NPM of 9.3%:
Using these assumptions, the following Bull case was obtained, with the same company-wide ideas generating cash flow as in the Base and Bear cases:
I then applied the Bull case to a sum-of-the parts approach, using the same style as described in the Base and Bear cases:
Combining the two parts, leads to a valuation of $37.63! The Snacks segment matters 1.5x as much as the Nuts segment. Once again, the market is thinking only of the nuts businesses instead of the other two brands (Pop Secret and Kettle) in terms of generating growth.
With an equity offering of 10M shares and applying the same method as the previous case equity offerings would lead to a total business valuation of $17.32:
On a sum-of-the parts- equity offering basis, a valuation of $31.38 was obtained with $16.53 and $14.85 from Snacks and Nuts, respectively.
Given all of these approaches my price range is $15.50-$34.60, with an expected FYE13 price target of $22:
There is almost no doubt to me that an equity offering or a spin-off is coming within the next year. However, this will help the company more than it will hurt and investors should use this as a great entry point on a pullback. Remember the likes of Green Mountain Coffee Roasters (GMCR) and Netflix (NFLX) last year? No one wanted to touch the shares of these companies but yet they continued northward. My point is, given the margin expansion, pay-down of debt, and solid results from its Snack line, DMND presents a better risk/reward than most give it credit for.
Disclosure: I am long DMND.