Diamond Foods, Inc. F3Q08 (Qtr End 4/30/08) Earnings Call Transcript

| About: Diamond Foods, (DMND)

Diamond Foods, Inc. (NASDAQ:DMND)

F3Q08 Earnings Call

June 3, 2008 4:30 pm ET

Executives

Michael J. Mendes – President, Chief Executive Officer

Steven M. Neil – Executive Vice President, Chief Financial and Administrative Officer

Robert Philipps – Treasurer, Vice President of Investor Relations

Analysts

Kenneth Zaslow – Bank of Montreal

Brett Hunley – BB&T Capital Markets

Mark Argento – Craig-Hallum Capital Group

Phil Turpoli – Longbow Research

Diane Geissler – Merrill Lynch

Mark Churchill – Piper Jaffray & Co.

Sarah Lester – Sidoti & Company

Sean Diforo

Operator

Good afternoon. My name is Kara and I will be your conference operator today. At this time I would like to welcome everyone to the Diamond Foods fiscal 2008 third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question and answer session. (Operator Instructions).

Mr. Phillips, you may begin your conference.

Robert Philipps

Thank you, Kara, and good afternoon, everyone. Welcome to the Diamond Foods investor conference call and webcast to review the financial results of our fiscal 2008 third quarter, which ended April 30th.

Before we get started, we need to cover several housekeeping items. First, a printed copy of our prepared remarks is currently available on our website diamondfoods.com under the section titled “Investor Relations” followed by “Earnings Releases.”

Second, we've arranged for a taped replay of this call which may be accessed by telephone. This replay will take effect approximately two hours after the call's conclusion and will remain available until midnight Eastern Time on June 17th. The dial-in number to access the replay from the US or Canada is 1-800-642-1687 and 706-645-9291 elsewhere. The conference ID required to access the call, regardless of the number you have dialled, is 4667-5159. In addition, this call is being webcast live with a replay also available on our website.

Third, we want to remind you that during the course of this call we will make forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995, including projections of our results. Since actual results may differ materially from projections made today, we encourage you to learn more about the risks and uncertainties that affect our business by reviewing our SEC filings under the heading “Risk Factors.”

Note that our projections or forward-looking statements are based on factors that are subject to change and therefore these statements speak only as of the date they are given. We do not undertake to update projections or forward-looking statements.

Now I'd like to turn the call over to Michael Mendes, President and Chief Executive Officer of Diamond Foods.

Michael J. Mendes

Thanks, Bob. Good afternoon, everyone, and thank you for joining us. Participating with me on our call today will be Steve Neil, our chief financial and administrative officer.

We are very pleased with our operating performance for the third quarter. Based on our progress in generating earnings which exceeded consensus projections, we are raising the lower end of our full-year earnings guidance from $0.80 to $0.90 per share to $0.85 to $0.90 per share. Diamond’s projected 2008 earnings represent a 60% to 70% increase as compared to last year.

North American retail sales are trending towards a healthy 8% to 13% growth rate as we sustain our focus on the branded and value-added segments of our business.

We continue to right-size our ingredient and international business and, as a result, our full-year top line is expected to remain relatively flat as compared to last year. Due to this continued mix shift in our business we expect retail sales to represent nearly 70% of sales, up from 64% last year. Expanding the proportion of our business that is branded consumer focused is a critical indicator of our progress in structuring the business to enable long-term profit improvement.

During the third quarter our top line grew 3% as a result of the continuing mix shift into higher-margin retail business. Led by snack growth of 39%, North American retail sales grew 16% for the quarter. Our steady penetration in the snack category was encouraging since we faced a significant spike in competitive activity during the quarter.

In US grocery, Emerald had a 5.5% market share for the quarter and posted 14% growth for the four-week period ended April 19th, while the category leader declined during this same period.

We continue to make progress expanding our retail footprint, as demonstrated by Emerald’s retail distribution increase of 300 basis points to 87%. Leveraging the appeal of our new products such as Cocoa Roast Almonds and Sea Salt & Pepper Cashews, we increased distribution of our core, premium tree nut items such as Mixed Nuts, Roasted Almonds, and Cashews. Each item posted over 30% growth during the month and averaged a gain of six distribution points.

Looking ahead to the fourth quarter, we will drive snack sales in grocery by expanding our promotional tie-in with Coca-Cola as compared to our initial launch of this program last year.

In the drug channel, we are making progress in our strategy to utilize shipper displays to capture incremental sales opportunities. One example of our execution of this strategy is Rite Aid, which will feature our 40 count Power Panel display in 3,000 stores during July and August.

In the club channel, we are conducting in-store sampling demonstrations of Cocoa Roast Almonds in over 150 locations which carry our new 38-ounce club pack.

In the mass merchandiser channel, we will begin initial shipments of Breakfast-on-the-Go, our new trail mix offering located in the breakfast aisle. The rollout has been expanded to 2,900 stores and will be on shelf in July.

Some of this new distribution will help offset the volume we are lapping from an in-and-out program we ran in the club channel during the fourth quarter last year. We also will continue to capitalize on new distribution opportunities to position us to achieve our long-term growth objectives. As a result, we will incur incremental slotting [which is contra revenue] that may have a greater impact on net sales this fourth quarter as compared to the same period last year.

Culinary sales increased 7% during the quarter, and are now 11% ahead for the year. Since the third quarter is not our primary promotional period for culinary nuts, most of the growth came from pricing instituted in the first half of our fiscal year in order to offset higher input costs.

Our ability to take pricing while maintaining revenue growth is a reflection of the strength of the Diamond brand. This is best illustrated in the grocery channel, where Diamond’s average selling price per pound was up 16% during the quarter while distribution remained steady at 90%.

Despite a smaller walnut crop last fall, we elected not to purchase additional raw material for our non-retail segments and instead chose to rationalize less profitable business while protecting and preserving strategic long-term customers. As a result, sales declined about 15% in this segment while gross margins doubled.

In summary, we continue to manage our business with an emphasis on long-term profitable growth, which has allowed us to raise the lower end of our EPS guidance for the year. With that I would like to turn the call over to Steve Neil.

Steven M. Neil

Thanks, Michael, and good afternoon, everyone. I’ll keep my remarks brief and focus on key financial highlights for the quarter. Please note that both the press release and the 10Q were filed today.

Looking at sales, our mix of retail sales increased 720 basis points over the third quarter last year to 66% driven by higher snack and culinary sales and lower non-retail sales. This is consistent with our strategy to shift sales to higher margin products, as Michael noted.

Turning to gross margin, gross margin for the quarter was 17.3%, well ahead of last year’s 14.1%.

Gross profit per pound shipped increased almost 70% to $0.63 in the quarter and this was despite lower volumes and higher input costs that resulted in an increase in cost of goods sold per pound of 31%.

The gross profit improvement was driven by favourable product and channel mix, as well as benefits from a number of cost efficiency initiatives. Examples of these initiatives include where we increased snack processing and packaging efficiency in our Stockton facility by more than 10% in non-commodity areas. We invested in two major energy reduction projects [HVAC and lighting] which has reduced our plant energy usage and lowered costs on an absolute basis. We also instituted a forward warehouse reduction plan that lowered both inventory levels and miles driven. These are just a few of the projects focused on long-term efficiencies.

Moving on to operating expenses, SG&A expense, excluding stock compensation, was $8.2 million compared to $8.1 million last year on a 3% greater sales base. On a year-to-date basis spending is down $1.6 million or 6%, while sales have increased 2%.

Advertising expense was $5.3 million compared to $7.3 million in Q3 last year, and $17.1 million through nine months compared $15.6 million last year. The differences between years are due to timing of our advertising spend. Full-year spending should be between $20 million and $22 million.

This all results in EPS for the quarter of $0.07 per share, up from last year’s loss of $0.25. If you recall, last year’s EPS included $0.20 in pension and restructuring charges partially offset by about $0.04 in discrete tax adjustments. Excluding these items, EPS grew from a loss of $0.09 last year to a profit of $0.07 this year. This puts us at $0.75 in year-to-date EPS which is 53% over last year, and we expect to earn $0.10 to $0.15 in EPS during the fourth quarter compared to $0.05 last year.

Our net cash position for the quarter was $5.4 million, compared to a net debt position of $22.9 million at the end of last year’s quarter. For the nine month period our usage of operating cash flow was $3.3 million compared to a usage of $35.8 million for the same period last year. For the full year, we expect adjusted EBITDA to be between $36 million and $38 million.

And finally, we paid a $0.04.5-per-share dividend on April 25th, which is 50% higher than the dividend we paid in the third quarter last year.

From a full-year guidance standpoint, we’ve left our sales guidance unchanged but raised earnings guidance to $0.85 to $0.90, as Michael noted earlier. This change reflects improvements in gross margins which, as we indicated in the press release, should be at least 16.5% or 150 basis points above last year.

With that, I’ll turn the call back over to Michael.

Michael J. Mendes

Thank you, Steve. At this time, we’d like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Ken Zaslow.

Kenneth Zaslow – Bank of Montreal

Good afternoon, everyone. Just a couple of questions. One is, can you give us kind of an outlook of how you’re saying about the commodities going forward and how the crops are coming out and what your perspective is on that?

Michael J. Mendes

Sure, Ken. Let’s just start with the walnut crop. Last year the California walnut crop was about 320,000 tonnes. Just as a reminder to those people on the call that most of the walnuts consumed in North America are US production. So that’s kind of the biggest driver to supply and demand. The two years before that were 360,000 and 355,000 tonnes, so the 320,000 crop last year was a shorter crop, prices accelerated. Going into this upcoming crop people are expecting this crop to be large, perhaps the largest crop in history. It’s a little early to say, but we would consider that in light of the early set of the walnut crop this year we would think that there’s probably a good chance that we’ll at least see prices stabilizing going into next year with what we see on this crop on walnuts.

As far as almonds, the almond estimate came out and the most recent estimate would project that the crop would be about 80 million pounds larger than last year and the carry out right now is projected to be about 20 million pounds larger than last year, which would give you an additional 100 million pounds of almond supply this year compared to last year. So almond prices are trading at a level that’s about half the price of walnuts right now in terms of a kernel price basis, so I don’t know if that’s going to mean much significant price reductions. I think some of that supply is already affecting the pricing, but that might have some influence in that direction if that crop bears out.

As far as the pecan situation, next year is the off-crop with pecans and the off-crop with pecans historically has been sort of about 185 million to 250 million pounds compared to north of 300 million that they had last year on the on crop. The inventory situation can somewhat influence total supply, but I would say that conventional wisdom is that pecan prices will be higher next year in light of the upcoming crop.

As far as peanuts and cashews, smaller part of our total mix but obviously an important business for us going forward as we grow in snacks, the peanut plant and acreages reported for the coming fall is reported to be up 16% this coming fall. If those actual plantings take place that should put some more supply into the peanut market which might have a tendency to mitigate some of the price pressure we see in that commodity. I would say the potential right now, if those acres that are currently purchased to be planted in peanuts, that might have a downward pressure on pricing.

With cashews that has been a commodity that had quite a bit of volatility. Cashew prices have increased about $1 a pound over the last six to nine months. The Indian and Vietnamese crops are being harvested right now. Based on those crops, we don’t see prices weakening. If anything they will stay at their current tight levels. As a matter of fact, there has been people that have been defaulting on contracts. The Brazilian cashew harvest takes place in September. That’s probably the next event that would lead to a relief in cashew prices and we don’t anticipate to see much relief, if we would see relief, until September.

Kenneth Zaslow – Bank of Montreal

So summarizing that, it seems like going into next year you would argue that your commodity pricing, the pressure from commodities should at least stabilize if not be a little bit, you expect a little relief. As a pool of your commodities on the nut. Is that fair?

Michael J. Mendes

I would agree with that.

Kenneth Zaslow – Bank of Montreal

Okay. And then in terms of your two largest customers, in you 10Q you put it out so it’s not, it seems like you are gaining a lot more traction in those two customers. Can you talk about what you’re doing differently? I know it’s not broken down by snacks versus culinary. Is there something specific to one of the sides of it that you’re seeing the growth or is it blended? Can you just talk about what you’re doing special in those two customers?

Michael J. Mendes

Well, I think probably if you break it down by business segments, because I think what we’re doing in culinary versus snack drives different results. I think that on culinary our reliability of the quality behind our brand and our reliability at supply in a period of time that some of our competitors have either compromised their quality or have actually short-shipped customers, I think it’s very much bode well for us and helped sustain and allowed us to get some new IRI with some of our customers that we have distribution, but we’ve had a chance to get some new items. I think that credibility has enabled us to pass a bit of pricing that we had to pass on because of input prices. We were able to bear that effectively and I think the IRI data supports that that worked out reasonably well for us.

On the snack side, Ken, I think we’re learning. I think we’ve got better packaging, some better new products, better execution of our promotional distribution, and also getting a better selection of items on the shelf on a better location. I think that if you were to look at our retail distribution in terms of which items we had on the shelf and where they were located on the shelf 24 months ago you’d see quite a different picture than you’d see today on some of the traditional retailers, and even on some of the mass merchant club partners that we’re working with.

I’m pleased with the progress. I think we’ve got a lot of runway ahead of us. I think the exciting thing for us is, I think that if we can execute against our distribution expansion plans by channel and continue to get the kind of velocity we’re seeing with our promotional effectiveness is going to continue to bode well for us in the next 24 to 36 months.

Kenneth Zaslow – Bank of Montreal

And then my last question is, I know it’s early for 2009, but with at least stabilizing commodity prices and it sounds like some traction with certain customers and new products, can you kind of shape us or give us some levers that we should be thinking about and how you’re thinking about 2009. Obviously specific details would be great, but at least the general parameters of how do we think about 2009.

Michael J. Mendes

Well, you know, we’re going to give a lot more detail about that, Ken, in our next call, but let me try to speak towards your question. I think that on the overall margin front we’re going to be working very hard to improve the cost efficiency of our business. In Steve’s part of the call he talked about some of the things that we’re doing that’s going to drive real costs out of our system, which we’re quite excited about because that’s, to me, cost reduction that doesn’t compromise your service or your quality is a gift that gives forever.

Unfortunately, some of those movements have really gone to offset some increases in fuel and energy costs that we’re dealing with in the environment, so we’re not seeing as much of the benefit of that. Hopefully we’ll keep seeing the benefit of that. We are investing more on that front. But I think that we’re probably going to see the benefit of that more in the two to three year window. I think we’re going to see continued investment in our capital efforts to drive efficiency of our operating facilities and take inefficient labour and inefficient processing and yield loss out and trying to apply capital to help deal with that. Which really wasn’t an option for us in most of the 90 plus year history when we were capital constrained.

As far as the general commodity environment, if commodity prices were to stabilize this coming year I think we will see a bit of benefit from us not kind of running behind commodity input costs as we deal with our pricing to our trade partners. So there could be a little continued, that would be a benefit that I think allows us to achieve our long-term earnings projections.

On the snack front, we really are committed to our 2011 target of growing this business next to $200 million. A big charge that we’ve had here in the company is saying 2009 will set up 2010. In 2009 we need to really get the right products in the right retailers with the right location with the right merchandising plans to really fuel the long-term growth of the business. While I think that in 2009 we’re going to make some nice progress in terms of the trajectory of our snack business, we are probably going to see only a smaller part of the actual sales driven out of that because we’re going to make sure we get it right. I think that’s a big key. I think in the past we might have scrambled a bit with the customer and if they said, gee, you know, you got 15 items and I like these four items because two of them are unique to my set, I think we’re going to slow down and really try to drive that we get the items that are the big velocity movers on the set.

If I had to be self-critical of our enthusiasm to rapidly get on the shelf in the past was sometimes when a retailer came to us and said, you know, you’ve got these mainstay items like mixed nuts, cashews, almonds. I like those, but I already have one of those and I have one of those in my own label. Why don’t you give me one of these nice unique items. And then they put that item on the shelf, they want full slotting, and then they expect to measure the velocity against that unique item against a base snack nut like a cashew or an almond or a mixed nut. That in the end was not the best thing for our franchise. That’s why a big drive in our business is to get those core items. To less mixed nuts.

So I would say that’s what I can sort of give you directionally on 2009.

Operator

Your next question comes from the line of Diane Geissler.

Diane Geissler – Merrill Lynch

Good afternoon. On your fiscal 2008 guidance and the drop in on the fourth quarter, if I look at your total snack revenue guidance of, I believe, $85 million to $95 million. That’s correct, right?

Michael J. Mendes

Yes.

Diane Geissler – Merrill Lynch

And I look at your snack revenue last year. Obviously that’s the fourth quarter. There’s a big swing here of $10 million in the July quarter. Anywhere from down 10% to up 30%. Is there any way to think, can you give us some examples of why you would be on the lower end or why you would be at the higher end? One versus the other?

Steven M. Neil

Thanks, Diane. I’ll try to speak to that. We had quite a bit of discussion about that. We have a number of initiatives that we are working with our retailers to gain distribution here that the timing of that could take place in the fourth quarter. I would say that the natural trajectory of the businesses were probably coming out towards the middle of that guidance right now and maybe a bit below the middle if we pay some incremental slotting that we’re looking at that’s a real nice opportunity, but that the timing is basically at the very end of the fourth quarter. So that’s a little bit behind that.

We also have some new distribution that we’re working on that if we actually were to get some of those shipments we could realize some of that in July, which could drive that number up.

At the current commodity prices an incremental customer with their front end orders can drive a couple million dollars of sales one way or the other. Our feeling was that it’s a growth business. I think that there’s a lot of volatility on the spikes of cost and revenue that drive this business. I think like anything it’s a rule of numbers. We’re going to be regressing towards a mean here over time. We’re going to see a lot less volatility in our snack business. At this point in time I think we’re, we think it’s prudent to keep the broader range to afford us to not do anything to compromise our distribution objectives because we narrowed our guidance.

One thing is, we did have an in-and-out promotion that was worth maybe $3 million or $4 million that we did in the club channel in the fourth quarter last year that was opportunistic. More like a sampling opportunity, to be honest with you, of one of our items. It was a nice opportunity that we partook in, but that was not going to be an annualized opportunity. So we’re going against that number in the Q4.

We’re pleased with the trajectory of the business, but I think that on Q4 we think we should be prudent and not be too ambitious with our guidance to afford us the opportunity to invest if we have a chance to position us better for 2009.

Diane Geissler – Merrill Lynch

And the new breakfast item that you say will be on the shelf in July. Would that have already, it wouldn’t have already shipped, right? It will ship in the fourth quarter.

Steven M. Neil

That will be shipping in the fourth quarter. So some of the timing of that will be a factor, for example. We’re still rolling out the schedule of when that fully will ship out. There’s two items and 2,000 stores in one case and 2,900 stores in the other case for those two items.

Diane Geissler – Merrill Lynch

Okay. So two items in 2,000 and 2,000 in 2,900?

Steven M. Neil

Yes.

Michael J. Mendes

Two-thousand and 2,900.

Steven M. Neil

One’s in 2,000, one’s in 2,900 stores.

Diane Geissler – Merrill Lynch

Oh, okay. All right. Thanks. In response to your response to Ken about how we should think about snack nuts, if I look sort of year over year somewhere around mid-teens for 2008 versus 2007, you want to be prudent, you want to build the business right. Should we be thinking a similar growth rate for snack in 2009? Or do you think you can do something better?

Michael J. Mendes

I would probably think that if you were looking at sort of the mid-ish point of our range I think we could probably do better in 2009. But I think we’ll have more colour on our next call to give you more scale on that. I think we would do better, but not –

Diane Geissler – Merrill Lynch

Are you saying better than the 90 whatever you’re going to do this year or better than the –

Michael J. Mendes

Better than the growth rate.

Diane Geissler – Merrill Lynch

Okay. Better than the growth rate. Perfect. Thanks for the clarity.

And then, I guess if I look at your SG&A and the roll off of the IPO equity comp next year, I have that at about $2 million but I’m assuming that there will be higher broker fees as your snack, is that still an accurate assumption?

Steven M. Neil

Diane, it’s Steve Neil. Yeah, you’re almost right on. Seven to eight cents EPS impact, which is right around $2 million for the IPO roll off. So you’re correct there. I’ll let Michael address the brokerage costs.

Michael J. Mendes

I think brokerage costs will go up a bit, but I think we’re going to see more of our growth in the non-brokerage driven channels, so it won’t be proportionately up as much.

Diane Geissler – Merrill Lynch

Okay. So it would be accurate to look at, you’ll have a benefit from reduced equity comp from the IPO roll off, but it might not be the full $0.07 to $0.08 because there might be some incremental broker costs?

Michael J. Mendes

This is correct.

Diane Geissler – Merrill Lynch

Right. It’s kind of a convoluted question, but I’m just trying to figure out what the upside on the equity comp is in 2009 versus 2008.

Michael J. Mendes

Yes.

Diane Geissler – Merrill Lynch

Okay. And then I guess just one technical question on the tax rate. It looks high in the quarter. I’m not sure if there’s anything specific going on there.

Steven M. Neil

Yeah, I’ll address that. You are correct. It was 41.5% versus 38% and there was just a small discrete item, a one-time item that came in. On an ongoing basis we still project 38% to be our effective tax rate.

Diane Geissler – Merrill Lynch

Okay. Would that be the annual rate then?

Steven M. Neil

Correct.

Diane Geissler – Merrill Lynch

Okay. I think that’s it for me now. Thank you.

Operator

Your next question comes from the line of Mark Churchill.

Mark Churchill – Piper Jaffray & Co.

Hey, good afternoon. You mentioned in the press release competitive promotional activity. Can you elaborate on exactly what you’re seeing and what your response was to that and whether that has any potential impact on the snack penetration in the fourth quarter like we saw a couple quarters ago?

Michael J. Mendes

You know, we have seen some promotional activity in the third quarter that has abated, we believe, going into the fourth quarter. Actually, we’ve seen some of our competitors, the national brands, taking a price increase in the snack categories. So we don’t think we’ll see on the pricing side, kind of the net pricing promotional activity, to the degree we saw in the third quarter.

Mark Churchill – Piper Jaffray & Co.

Okay. And then could you provide some more colour on the volume and pricing trends in culinary and exactly what you guys are seeing for cost inflation in that business?

Michael J. Mendes

Yeah, you know, it’s an interesting thing. When we first took our pricing in the category, the biggest concern when you’re the national brand and you’re leading the category is are people going to follow and how is the private label going to treat that increase. I think that if you look at our dollar share growth in the 50 to, four-week, between the 12-week and four-week periods, let me just give those to you, Mark. In the 53-week period our Diamond baking dollar share is up 3.7%, for the 12-week period it’s up 5.8%, and for the four-week period we’re up 11%. So I think what you would note is that, and that’s with a very, very modest volume decline during that period is that what we’re seeing is we’re holding a distribution and our loyal consumer bases. Perhaps that worst case may be shipping to smaller pack sizes as a reaction to the inflationary environment. While we would always hope people would buy as much volume at the full price as possible, if people are going to have a reaction in an inflationary environment to sort of stay within our franchise and to trade off to a smaller pack size that would be the most desirable inflationary reaction we could see. I think that’s what we’re seeing.

Mark Churchill – Piper Jaffray & Co.

Okay. Thank you very much.

Operator

Your next question comes from the line of Heather Jones.

Brett Hunley – BB&T Capital Markets

This is Brett Hunley. How are you? Good quarter. I just wanted to touch on gross margin again. Steve, you touched on this pretty well in your prepared remarks, but as you look at it, it just continues to improve here. It’s something where you see that trend continuing into Q4 and kind of, if you can touch on a lot of these efficiencies that you’re driving when they continue to fall in line.

Steven M. Neil

Yeah, we do expect it to continue into Q4. The efficiency initiatives that we identified, I mean, that’s an ongoing effort. We identified a little bit of detail there. Clearly we’ve just completed, for example, the energy initiatives here in the last couple of months. So to get the full benefit of that, that’s going to continue going forward. Your goal is to, whatever your cost increases are, whether it be inflation or commodity, you try to offset it with cost efficiencies. That’s certainly what our focus is. We’re not always able to do that – obviously you have to have some price increases – but we certainly expect that to go forward.

I think the other thing to emphasize over time is, we have put in capacity to meet demands in the snack category and, to a little bit lesser degree, in culinary. As you drive more volume through your fixed costs are there, so you’re going to get some benefits there too. As we talk about benefits both in the by channel and by mix, that’s what we mean. So again, as we grow that’s going to be a benefit and we’ll continue to realize the efficiencies on the margin side. I think we’ve stated before that as we get up to 2011 we expect margin to expand up to 20%. So while it won’t be linear it’s certainly going to be directionally correct.

Brett Hunley – BB&T Capital Markets

Okay. Thank you. That helps.

The other question I had was, have you guys been seeing a trade down to private label in snack nuts?

Michael J. Mendes

You know, on the private label front we’ve been watching that very carefully. Both in culinary and snack nut we’ve seen private label make some gains this period, but we are pleased to see that a lot of that gaining seems to be coming at the expense of the all other brands which are really price sensitive brands that don’t have any unique packaging or flavours and don’t have any national consumer support. So we have seen some erosion from those brands, particularly in the snack category. I think that private label, you know, one thing that I would like to refer to private label as only, well, I mean, the retailers, it is their brand. They take it very seriously and treat it as their brand. Part of our value proposition is we have a path to prosperity which is enriching for the retailer and their brand while we can succeed. So a big part of what makes us attractive as a new entrance into the category is our ability to grow, to grow share, and to not cannibalize the retailers brand or the national brand, which generally means it comes after these regional one-off brands that don’t support or provide value.

I think own label, the retailers brands are doing well in this segment, but I think that in the end of the day a national brand, ourselves, and own label is a very optimal environment and I think in this period we’ve moved more in that direction. So it’s something that is out there and I think brands, I think as long as your brand is bringing value and you have a lot of promotional activity and you’re helping to bring consumers to the set, I think you can bode quite well in this environment. But it really is a test of your mettle of the brand of whether it brings them to the party because otherwise I think you really risk losing to private labels or to store brand in this environment.

Brett Hunley – BB&T Capital Markets

Right. Michael, your ingredient segment held in there better than I think we had expected. Can you talk a little bit about the performance in that segment?

Michael J. Mendes

Yeah, you know, we continue to focus on our value added customers and customers who value the brand. I would say if you were to profile our core ingredient in food service customers they tend to be a customer who sells a product that they are craving something for the consumer, so it’s a more processed item. Nuts added value in the premiumness of the product. It helps them sell the product for more money because it adds, it distinguishes the product, it makes it more premium. So nuts are not something that adds cost, it’s something that adds value. And also that nuts represent a relatively small percentage of cost of goods sold. You put all that together and you’re not going to want to see that commodity price inflation. But if it’s a pretty small percent of the COGS it’s not going to nowhere near offset the value increased potential of that item.

So our customers, and because that, versus sort of the other kind of agreeing customer might be a reseller, a bulk reseller who is really a short coupled pass through vehicle to some other end customer. They could be very much subject to a very aggressive reduction and demand if they’re business is a high inflationary environment. That makes a very small subset of our customer base and that’s helped us a bit there.

And finally, our international business. We continue to take opportunities in this weak dollar environment. Walnuts are still a very attractive value vis-a-vis other foodstuffs given how much the dollar has declined in value versus the year in particular and also against the yen over the last three or four years.

Brett Hunley – BB&T Capital Markets

Okay. Great. Thanks, guys.

Operator

Your next question comes from the line of Mark Argento.

Mark Argento – Craig-Hallum Capital Group

Good afternoon, guys. A couple, or one really question for you here. Now that you’ve had the snack business now for a few years. Can you talk a little bit about your marketing spend? I know you’ve kind of fixed that out. What did you say, $20 million to $22 million? Now that you’ve kind of treated the strategy in terms of go to market, tried to get more skews fumbled together, trying to drive better penetration that way. Has that really affected how you approach your marketing spend and can you talk a little bit about any changes there that we should be anticipating or any adjustments that you’ve already made there?

Michael J. Mendes

I think the one thing that sort of belies the marketing spend, which due to accounting treatment is quite visible, versus promotional spending, which is very important to stimulating off take which is net of sales, when you aggregate the resources against the brand you’re probably looking at promotional support of $30 million plus dollars on top of a $20 million advertising budget, whereas two and a half years ago we had maybe $10 million of promotional support against that brand. That promotional support is really critical to get the kind of display activity at retail and it is still quite an impulse purchase category. So when you overlay that incremental promotional support that we’re going to power against this category, that is quite a resource expansion for us. In addition to, you know, we have broker partners that are part of our sales arm that merchandises and manages this category.

As you can imagine, in regions of the country where we have bigger volumes and more critical mass in dollars we buy attention naturally. But there’s a lot of regions of the country that on a smaller base those sales dollars were smaller and we didn’t afford a lot of attention from our retail partners in merchandising the products. As we’ve scaled up we’re improving our visibility and capability on that front. So the aggregate effort that we’re able to by behind a brand is quite a bit stronger today as compared to three years ago juts on the scale of the brand.

And the final thing is, we’re trying to spend those advertising market dollars even better. At the beginning there was really no perception of the brand. Now that recognition of the brand has started to register we’re able to spend to really build relevance in the brand. So I think that I would look at it as a critical mass investment and I think that given that we’re having to spend on top of the base that we’re operating, it’s a good base to operate. Obviously we would love to keep selling the business and afford to spend a bit more against it, but we feel very enabled with our current investment level.

Mark Argento – Craig-Hallum Capital Group

Do you know off the top of your head how much you guys are spending on line right now and do you guys look at that channel as kind of a key differentiator for you because you are targeting a little bit younger demo?

Michael J. Mendes

You know, for competitive reasons we have not disclosed the specifics, but I would like to speak about that for a moment. I think there are two fronts to that. One is, I think it’s very, very intriguing to us how we can reach out to our consumer base. You’re absolutely right, because we are focusing on a bit of a younger demographic their accessibility is that much greater given that venue. I think we’re still in a bit of a frontier in terms of CPG companies leveraging that instrument to effectively get consumers. We’ve got some things we’re working on there that we think is quite exciting. At the end of the week we’re, actually next week we’re going to refresh our website with some new changes and improvement. There’s no doubt that we spend a lot more time talking about on-line resources and how we can institutionalize our efforts on that front as well as periodically exploit that.

I think that as far as more sophisticated, if I can broaden your question or if I can also speak at least to a broader subject, which is more sophisticated tools for us. When we launched this brand our vehicle to promote the item was a national FSI. We would put in national FSI in a Sunday circular. Very broad, crude instrument. Still a very tried and true vehicle from new product trial, but a bit of a problem when you have spotty distribution of some of your items. So one thing that we’ve been doing some work on is a vehicle called Catalina, which you’re probably familiar with, which allows you to actually go and select the store, select a region, and select a consumer demographic. Then not only have a coupon print out on the register, on the receipt at the register, so basically you get a colour coupon which redeemed on the back of your, at the register, and we can actually change the redemption based on your purchase patterns. So for example, if our research shows this consumer will traditionally buy one, they normally buy one bag we’ll try to give them incentive to get them to buy two. If people normally buy two packages we’ll create an incentive where if you buy two you get a discount off of the third. And the efficiency of that spend we think is just going to be a better use of our dollars and a better application of our approach.

I think kind of the broader subject, are we trying to drive more intelligence into our marketing, I think the answer is yes. I think the on-line universe, our best data is still in front of us, but we’re making progress there.

Mark Argento – Craig-Hallum Capital Group

Great. Thanks for the colour.

Operator

Your next question comes from the line of Alton Stump.

Phil Turpoli – Longbow Research

Hi. This is actually Phil Turpoli [sic] calling for Alton. I wonder if you guys could shed a little more colour on the competitive landscape with the new trail mix products. Maybe what you expect to see there and also what types of seasonality, if anything, we should expect from them.

Michael J. Mendes

Well, there’s always a host of new products out there. We know the national brand has got some trail mix items which I think they might be doing success with them but they’re going for a certain price point on that. I don’t know how much novelty. I know they’ve got a different peanut product that they’re working out with. I think it’s still early on their distribution efforts there. We know that Pepsi has a brand that they have introduced in the nut category that’s more of a convection type item. It’s a blend of products, but it’s more of a confection, sweetened item. I guess I would consider this to be a new type product to the set.

Our whole thinking is that, you know, when national brands bring innovation to the category and spend dollars on marketing to draw consumers to the shelf, that’s great news for us. We don’t really see it as a better mousetrap against items that we’re marketing, but it’s something we’re monitoring closely. When we look at some of our new introductions like the Cocoa Roasted Almond we think that it’s very on trend product. We think that people like almonds. We know that people like chocolate. But generally a chocolate almond is an in-road product that needs to be refrigerated, that feels more of a decadence product. Our new Cocoa Roasted Almond basically has not additional caloric value as a result of the chocolate roasting. Which is very appealing for people who like a nut as a healthy snack but would like to get a chocolate flavour.

So we really like how we’re lining up on the innovation front versus some of the other players out there. This is sort of a trench warfare. It’s every day what have you done for me lately. We like where we are today. We have some more things in the pipeline and we think we’ll bode well going forward.

Phil Turpoli – Longbow Research

Okay. Great. Thank you.

Operator

Your next question comes from the line of Sarah Lester.

Sarah Lester – Sidoti & Company

My question is about the slotting fees for the fourth quarter for Emerald. You mentioned in your prepared remarks that slotting is going to have a greater impact on the fourth quarter. Can you expand on that a little bit?

Michael J. Mendes

We don’t guide specifically on that component of our costs. I would just say that compared to fourth quarter last year if we do have an opportunity to get some products in place we will not slow that down in order to back into a fourth quarter sales number.

One of the things, Sarah, about our business that’s been interesting as we keep getting better in managing the business is we’ve put some guidelines as working with our retailers of when we’ll pay slotting. For example, we’re looking to get up to a minimum distribution level with a new item with a customer before we’ll actually pay the slotting.

So part of the issue is that I would hope that with some of our new items that we have in distribution that we have to pay the slotting because that means we’re up to the distribution that we want. But the net of that could be that it could have a cost revenue effect that I’m not forecasting in my guidance. So we try to leave some room for the unintended consequences of good work on our distribution front.

Sarah Lester – Sidoti & Company

Right. Okay. Thank you. And then also, with the water shortage in California, has that been a problem for any of your growers or could that become a problem?

Michael J. Mendes

Water is definitely always in the short list of issues for California farmers. The one thing that I would say, when you look at the whole farming universe, the higher yielding agricultural commodities tend to be at the top of the food chain of their ability to get to that water supply and their ability to capitalize their own operations to have pumps and their ability to access water. And also part of the decision and the land value is based on the land’s intrinsic ability to get water. So I would say if we were sitting here and maybe we were in cotton or row crops it would be a heightened concern. I would say it’s a concern, but I would say that it’s something that farmers are aggressively trying to address. But I think your question is a bit prophetic because I wouldn’t be surprised if we’re sitting here five years from now and I have a little different answer on that. But today I would say I don’t think that’s a short term issue that would have an impact on our business today.

Sarah Lester – Sidoti & Company

Okay. That’s all. Thank you.

Operator

Your next question comes from the line of Sean Diforo [sic].

Sean Diforo

Hey, guys. Just on the breakdown of the improvement in gross margin. You talked about mix, leverage, skew rationalization, some efficiency that I think falls into a couple of those buckets. Any way you can kind of break that down a little bit more for us, of the 320 how much came from or at least a generalization, and how much came from each bucket.

Steven M. Neil

You know, we’re not going to go down that path, Sean. I think it’s a good question, but we think each one of them will play out. Our target really is over the long term to get the gross margin up to 20% by 2011 and, frankly, the operating margin up to 10% in the time frame. So it’s going to be a combination of all of the above. Certainly now there’s, as Michael I think mentioned on the call or one of the questions earlier with Ken, we’re able to spend some capital that we haven’t been able to spend previously under the coop operations that enables us to drive a lot of these efficiencies. So you’ll probably see a little bit more actually operational efficiencies on that end now. I think as we move out in 2010 and 2011 you’re going to see a greater lift from just volume. The volume taking advantage of capacity and just working the variable costs.

So it’s a combination on all of the above and we really look at it on a long-term basis. So we really haven’t broken those pieces out.

Sean Diforo

Okay. And then on the international side, any quantification in that $5 million down year over year of what the skew rationalization was?

Steven M. Neil

I’ll take a shot at that. I think it’s more identifying where we’re going to allocate the product. On the international side we’re allocating the product more to the value added segment of the business and less to what I call more of a trading or a coop legacy. The skew reductions are more in what we’re looking at, for example, in the harmony acquisition we acquired quite a few skews and we’re working very, very aggressively to hold those skews that frankly don’t have adequate volume that we can get a return with pricing. So that’s in part where we’re trying to focus on efficiencies coming out of the plant. So when we say skew on the international side I think it’s more the customer that values the value-added components of our business.

Sean Diforo

Okay. Great. Thank you, guys.

Operator

There are no further questions.

Michael Mendes:

Well, thank you, everyone, for joining us. Before we conclude I just want to remind you of some investor events coming up. Next week we will be, on June 10th, presenting at the Piper Jaffray conference in New York. And then on July 1st we’ll also be at the Longbow Security Conference, which will also be in New York.

If you have any more questions about our investor events please visit our Diamond website. Thank you for joining us.

Operator

That concludes today’s conference call. You may now disconnect.

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