It has been an interesting week for Diamond Foods (DMND). They missed the 180-day NASDAQ deadline to file their delayed financials. NASDAQ will likely issue a delisting letter and Diamond will ask for a review hearing.
Market participants appear to be speculating on the severity of the fraud given the delay in filing the restatement. It is hard to know, however, what to make of the delay. I had a conversation with a friend, who is an internal auditor at a major publicly traded company. He told me, from his experience with restatements, that it could be relatively minor issues slowing the process down or it could be worse. Nobody, except insiders, really knows.
Trying to value Diamond's equity on an EV/EBITDA basis is difficult given the lack of information. I do think, however, there are enough data points that one could use to make conservative assumptions.
If Diamond reports less then $102 million of "Consolidated EBITDA" for FY 2011, then Diamond would be in default on its agreement with Oaktree. The $102 million of EBITDA lines up with what market participants expect, with the 40 million of netted momentum payments to growers being removed from $146 million of reported EBITDA for FY2011.
Assuming the restated FY2011 EBITDA will be approximately $102 million so as not to violate the Oaktree agreement, the issue for investors is whether that $102 million is growing, shrinking or stable going forward.
As explained below, unless Diamond's branded businesses produced significantly more operating profits, it is likely that Diamond's EBITDA is shrinking.
Diamond disclosed in its March 13th, 2012 press release that "Fiscal 2012 non-retail walnut sales were down significantly due to less supply…"
In FY2011, even after including the momentum payment, Diamond still underpaid their growers by upwards of 15 cents/lb (Growers say market discount was 45 cents/lb and momentum payment was 30 cents/lb). If Diamond had paid its growers the fair market value in FY2011, it is likely that EBITDA would have been $41 million lower or $60 million (assuming purchase of 277 million/lbs of walnuts in FY2011 with an additional 15 cent/lb discount).
The restated FY2011 EBITDA, therefore, still includes excess profits that are unlikely to be repeated going forward. This is based on Diamond's stated goal to pay its growers fair market value for their crop to regain supply, in order to prevent Oaktree from having better terms in the recap deal.
In addition, with supply significantly down this year, even if Diamond is still able to pay a 15 cent/lb discount, EBITDA would still go down substantially, unless you believe Kettle, Pop Secret and Emerald were able to make up for the decline.
For the sake of being conservative, however, I will assume Diamond's EBITDA is stable at $102 million, with the decline in the nut business being made up by the branded business. I think this is a very aggressive assumption based on the commodity pressure most food companies have been facing and the slow growth in the UK and the US (the primary markets for Diamond)
The Total Enterprise Value of Diamond at the current market cap is slightly over $1 billion (409 million of equity + $225 million from Oaktree + $375 million of bank debt utilized - with an additional $100 million of borrowing capacity on the facility).
In one of my previous blog posts, I argued that Diamond will have to tap its credit facility in order to make its final payment to growers in July for upwards of $90 million. But for purposes of this analysis, I will not assume any additional debt will be taken on by Diamond this year to fund its final grower payments in July.
Putting this all together, Diamond on a conservative basis is currently trading at approximately 10X EV/EBITDA (1.09 billion/102 million). This is a fancy multiple for a highly levered company in a stable but mature and highly competitive category, whose cost of debt capital has increased to 12% and whose earnings could be materially lower going forward. When you consider the potential dilution from the Oaktree warrants, along with the cost of the restatement (accounting, legal, consulting and investment banking fees plus any litigation costs), the fact that the market does not have three years worth of financial data and the company might be delisted, the valuation becomes even more extreme.
Both General Mills (GIS) and Kellogg (K) currently trade for approximately the same multiple of EV/EBITDA as Diamond. John Sanfilippo & Sons (JBSS) , the best comparison to Diamond's nut business and a beneficiary from Diamond's weakness in the business, trades at just over 5X EV/EBITDA.
So why does Diamond deserve the same multiple as General Mills and Kellogg and double the multiple as John Sanfilippo? General Mills, Kellogg and John Sanfilippo are very well capitalized, while Diamond's balance sheet is a mess. Plus no one has any earnings visibility on Diamond.
I think the answer to that question lies in market structure that has led to inefficiency with respect to Diamond's share price.
CEOs of publicly traded companies often complain about how short sellers are driving down their stock price. During the phase when large new short positions are initiated, the share price of a company will be under pressure. However, if all the shares available to short have been borrowed, then the shorting actually serves to keep the share price high, often irrationally so (see Sears Holdings for a prime example of this). This is because if there are no more shares available to short, then the trading on any given day will include only long buyers, long sellers and short buyers. There will not be any short sellers.
Based on info from brokers there are only 60,000 shares (.3% of Diamonds shares outstanding) of Diamond available to be shorted at a cost of almost 40%. As of May 31st, 10,405,616 of Diamond's 22 million shares are being shorted, which is 47% of total shares outstanding and 52% of the total available float of 20 million shares. The short interest has been at least 10 million shares since October 14th, 2011.
The shorts are all in and they have been so for some time. Short sellers are not what is keeping this stock down, it is what is keeping the stock up. Short selling helps keep the market efficient, but in extreme cases it leads to market inefficiency. I think Diamond Foods is prime example of the latter.
Ultimately this dynamic has an effect only in the short run; in the long run, Diamond's share price will reflect reality. But in the meantime, it presents opportunity.
Just some food for thought.
Disclosure: I am short DMND.