Diamond Foods Isn't A Diamond Stock

| About: Diamond Foods, (DMND)

Diamond Foods, Inc. (NASDAQ:DMND) is a vertically integrated food manufacturing company that packages, processes, markets, and distributes snack and nut products all over the world. Their brands include some of the food you munch on probably as you sit at your desk trading, such as Kettle Brand potato chips, Pop Secret Popcorn, and Emerald Premium snacks. From a customer perspective, their business seems straight forward, in which the company provides quality name brand products to retailer and wholesale customers throughout the world. But from an investor perspective, after reviewing their financial statements and press releases, I want to know if the company has a place in my portfolio or is just another runt of the litter type of company.


I'm an optimist when it comes to life in general, but when I'm thinking about parting with my money or have money on the line, I want to uncover the dirt and red flags that pop up as I research a company. So I'll start by pointing out the negatives. Roll up your shirtsleeves because it's going to get quite messy.


From Diamond's last 10-K filing there are six legal proceedings in which they are the defendants all involving whether the company made materially false and misleading statements, and/or failed to disclose material facts, regarding Diamond's financial results and operating results. These legal troubles all stem from management's accounting treatment of payment to walnut growers. According to an earnings release:

In February 2012, Diamond announced that their Audit Committee concluded that a 'continuity' payment made to growers in August 2010 of approximately $20 million and a 'momentum' payment made to growers in September 2011 of approximately $60 million were not accounted for in the correct periods.

As a result, the Audit Committee determined a restatement of 2010 and 2011 financial statements was required. In addition, during the Audit Committee's $17.4 million investigation and restatement, they identified material weaknesses in the company's internal control over financial reporting.

As an observer of the capital markets, there are two things I think of when a company needs to restate their financials: 1) Run for the hills and preserve capital, or 2) if there's a viable business underneath the pre-restated financial results, this might be a huge opportunity to obtain shares at a significant discount. I choose the latter, as we have time on our hands and can indefinitely wait for that perfect pitch to knock it out of the ball park. As shown in a few press releases since the restatement announcement, we know that no fraud was committed, but rather that management was incompetent and their auditor PwC was overpaid in not catching this prepayment to walnut growers during the 2010 and 2011 reporting periods. The question is, though, after the settlement of one of their securities litigation cases of $96.1 million: How many more material impacting settlements will come? The answer is unknown, but clearly management materially weakened the financial position and reputation of the company after the fact and has created ripple effects for years to come.

The most obvious ripple effect is the amount of capital the company raised from Oaktree Capital Management (NYSE:OAK) to strengthen their balance sheet, incurring $225 million in senior notes and warrants to purchase approximately $4.4 million of common stock. The notes pay an annual interest rate of 12% and the warrants are exercisable at $10 per share starting on March 1, 2013. What does this mean for common shareholders? Let me hold your hand on this one: The senior notes mature in 2020, and paying a rate of 12% for the next eight years the company will be paying $216 million in interest payments. Not to mention once the $225 million in principle comes due in 2020, the company will most likely be paying for refinance charges of the $225 million. Also, the warrants will materially dilute the existing shareholders as Oaktree will most likely exercise all of their warrants at $10. As of July 31, 2013, Diamond had 21.9 million shares outstanding. Let's assume that none of the Oaktree warrants have been exercised, which probably is the case as they want to support the stock and gain investor interest back into the company. Once Oaktree exercises their warrants all else equal, Oaktree will dilute the existing shares by 20%.

Management had no other alternative during their financial crisis per se in 2012 as the company almost went bankrupt and needed a lifeline from Oaktree. The problem with the money management, though, is it wasn't shareholder-friendly. Even during the best years of Diamond Foods the company would only have posted a minimal net gain with interest payments of $27 million a year. Due to the company's lenders debt covenants, it's going to be a while before the dividend will be reinstated and it will be difficult to raise capital for future acquisitions like the one the company pursued with P&G's Pringles business, which cost the company $7 million in a failed attempt. For additional negatives, look at the 2012 10-K "Risks Related to Our Business" section of the company's website.


Diamond Foods has a lot to be thankful for this holiday season as they haven't been de-listed from the Nasdaq and are still operating as a going concern. Their major customers are Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST), which accounted for 18% and 12% in 2012 of their sales. As a trader looking for some holiday shopping, I might purchase Diamond besides the typical retailer stocks given that they sell a lot of nuts between October and December for those holiday baked goods. Some highlights during the company's fiscal fourth-quarter results include the fact that snack sales increased 3% to $438 million and EBITDA increased 12.5% to $24.6 million. Besides that, it was a pretty bleak quarter and nothing to write home about.


As Diamond Foods continues to face financial headwinds from their lenders, litigation, and continued partners within the industry, I would say at best this is a stock for traders who don't plan to hold the company long term. The company has been taken over by the bankers and has their investors' interest as priority No. 1 to get their money back. For now, a key metric that I would use to determine the profitability of the company as a common shareholder is as follows: I would take their EBITDA and subtract just the interest payments they have to make each quarter, then I would divided that number over the diluted shares outstanding. This measure would tell me how much of a lag the debt burden is on the company and if the company can overcome it on a continuing basis.

The action I'd suggest for you as an investor is to stay away from the company, as it is in no position to expand given the debt structure. In addition, until management is able to restructure their debt in a way that doesn't dilute their shareholders -- as we have seen time and time again -- the common stockholders will be left holding the bag.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.