Diamond Foods: A Fallen Angel Can Mend Its Broken Wings

| About: Diamond Foods, (DMND)

Now that the Diamond Foods (NASDAQ:DMND) accounting investigation is "cracked" open somewhat, what is the outlook for the company and its stock price?

Collapse of the Pringles deal is a positive for DMND: We highlighted the onerous terms associated with Diamond's (now-failed) attempt to acquire the Pringles snack business from Procter & Gamble (NYSE:PG) in previous analysis (here and here). Indeed, while the strategic long-term benefits of the Pringles brand might have enhanced DMND's snack portfolio, little-fish eating big-fish can be a risky proposition. Call us relieved that the deal was terminated.

Corrective actions by the Board of Directors are important first-step to restore shareholder confidence: DMND's audit committee investigation into the timing and accounting of payments made to walnut growers took three months to complete.

You would not expect a forensic or discovery due-diligence process related to "continuity" or "momentum" payments to be a protracted affair, but apparently the Board saw it fit to dig deep and report their findings conclusively and accurately (we hope).

We now know that timing of said payments was not accounted for in the correct periods and that the audit committee identified material weaknesses in the company's internal control over financial reporting. And, the Board did the right thing by axing both CEO Mendes and CFO Steven Neil...immediately. After all, this mess happened on their watch.

Appointments of Director Rick Wolford (acting CEO) and Mike Murphy (acting CFO) suggest that the Board is taking the bull by the horns. Mr. Wolford is a previous chief cook and bottle-washer at Del Monte Foods, while CFO Murphy brings solid experience in areas of restructuring and operational skills to the company.

Motive(s) behind treatment of payments appears clearer now: Under the terms of the PG deal, DMND stood to incur massive equity erosion in acquiring Pringles. DMND would be putting up stock and assuming debt, but no cash. Below is a comment from our Nov. 2011 analysis regarding the potential outcome of the audit committee's investigation:

The question DMND might be trying to figure out is what possible impact would a restatement of earnings have on its current equity (against) the potential of further equity erosion resulting from the acquisition of Mr. Pringle?

From an accounting standpoint, Reverse Morris Trust transactions, such as how the PG deal was originally structured, are ridiculously complicated. It could be that the audit committee also realized after three months of investigation, the net effect of restatement(s) was onerous enough, without the added burden (and debt) of what would surely turn out to be a big bite to swallow (i.e. Pringles).

With the deal off the table, the board and management can now focus on getting their financial house in order, reassure creditors and lenders, grow their existing portfolio of brands, etc.

Criminal intent or just trying to look sexy?: Investors who were foolish enough to believe that DMND plus Pringles was or is worth $90 a share should have looked more closely to how the deal was structured rather than potential future earnings growth. He who dares sometimes wins, but investors who don't pay attention to the details will sometimes learn the hard way.

As for allegations of possible criminal intent by DMND management we offer a more sanguine observation. Ever since former chief executive Michael Mendes took the walnut "cooperative" public in 2005, the company has been moving away from the commodity-sensitive business of nuts into higher margin "branded" products.

You can't blame a chief executive for wanting to forge his legacy by exploring new opportunities. Other packaged food companies such as ConAgra (NYSE:CAG), Treehouse Foods (NYSE:THS) and now Kellogg (NYSE:K) are also jumping on the bandwagon of providing what consumers "want" not what they "need". The snack business is booming!

We have seen far more nefarious tactics employed by an acquiring company to get a deal done or to fluff earnings. With regards to DMND, the payments were made, just not recorded in the proper period. Obviously, booking an expense before it is realized or deferring recognition of it to a later period is going to distort the balance sheet.

Under GAAP rules, there are distinctions between "matching principle" accounting and cash accounting. Under matching principles of accounting, you establish the accounting period based on the expenses incurred and the income generated, not by cash-flow. Thus the difference between an accrued expense vs. a deferred expense.

While regulators may determine that DMND was negligent in its treatment of the payments, it's not as though the company is/was making up numbers out of thin air. For example, a company that resorts to channel-stuffing or manipulation of income producing assets to make their numbers would be in our view a far more heinous act of accounting skullduggery.

Keep in mind that PG originally structured the deal to be tax advantaged for PG shareholders. So, you can imagine that DMND wanted to look sharp for the big party.

On a side note, Kellogg is levering up and paying a rich 11 times trailing EBITDA to acquire the Pringles brand. This is expensive even for Kellogg, but if they can grow the business, it may look dandy three or four years from now. If DMND were to buy Pringles, they would go into the deal with a rope around their neck.

As for Mendes and CFO Neil, if they are guilty of anything, it is that they may have been thinking too far outside the "box" in their quest for Pringles. Given the complexity of the PG deal terms, enhancing the quality of earnings would certainly be a desired objective for Diamond's management team attempting to tackle such a big deal.

Nonetheless, DMND management really made a mess of things with its poor judgment on the accounting issues and the botched attempt to acquire Pringles. And, what does it say about Procter & Gamble's due diligence?

Anecdotal perhaps, but it is noteworthy that both companies (DMND and PG) released each other from all liabilities related to the proposed acquisition. No break-up or other fees are expected to be paid in connection with the termination.

From an accounting perspective, we see a company that may have tried too hard to reach the big leagues. Not a company trying to rip off investors. While the $80 million disclosure is a serious matter, we see no obvious pattern or glaring indication of financial engineering within the financial statements.

What about DMND stock? Barring any additional potential accounting bombshell(s) we are sticking to our $38 p-t on DMND shares. Uncertainty is the biggest cloud facing the stock, but we are much encouraged by DMND's board in moving quickly thus far to address the problems.

New management has articulated a desire to repair relations with its growers and any news regarding the restated earnings will help to bring some clarity to the company's financial situation. Yet, many questions remain and there is of course going to be some attention placed on DMND's outside auditor Deloitte and Touche

Operationally, management may want to focus on improving cost controls and capital productivity. Litigation and compliance expenses will be an added drag to income, but we expect some of the class action complaints alleging that DMND may have "intended" or "attempted" to defraud investors to be dismissed.

Maximizing returns on assets is another tactical strategy management will likely address. We see potential improvements in capacity, inventory and receivables (per each dollar of sales) as areas to focus on (see table below)
Diamond Foods Revenue Metrics

Bottom Line: At $24 and change, DMND is a fallen angel trading at a low multiple of cash-flow and sales. Emerald Nuts, Pop Secret and Kettle brands enjoy high consumer awareness and generate solid cash flows. If management can show regulators and investors that they mean business, we see every reason for earnings and share price to move higher.

Takeover chatter has been active in recent days and shorts control over 50% of the share float. A dividend cut (or suspension) would not be a surprise given the circumstances.

We are currently long DMND (small positions) with an average cost-basis of $32.65. Although much cheaper now, we will assume a 10% (downside) headline risk and look to add to positions in the $22 area.

Disclosure: I am long DMND.

Additional disclosure: Sources for article: merriamreport.com , NY Times (Dealbook), Reuters, SEC Edgar

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