It Is Too Early To Take A Chance On Diamond Foods?

| About: Diamond Foods, (DMND)


Diamond Foods has had a rough five-year period due to some corporate missteps, which have left shareholders with a negative cumulative return.

The company's financial results seem to be improving in FY2014 though, which has put a tentative bid under its stock price.

With its nuts business still in decline, it is too early to buy the story.

Packaged food manufacturer Diamond Foods (NASDAQ: DMND) is still trying to regain its former business momentum that was short-circuited when an accounting scandal, since settled, almost did the company in back in 2011. While the company survived, thanks in part to a $225 million financing package from investment firm Oaktree Capital, it has clearly struggled to find profit growth. A large part of Diamond Foods' problem has been a rise in overhead costs, especially in the area of compliance, a byproduct of its need to improve its internal control environment. In addition, the company has anecdotally been hurt by rising international competition for U.S. nut farmers' output that has led to lower available supplies, culminating in sales declines for its nut segment.

On the bright side, though, Diamond Foods has offset some of its nut segment's weakness by focusing more on the growing snacks business, more than 50% of its current business mix, a product focus that has also worked well for competitors, including Boulder Brands (NASDAQ: BDBD). So, is Diamond Foods a good bet at current prices?

What's the value?

Diamond Foods is one of the country's largest sellers of packaged nut products, a natural byproduct of its history as a co-op of California walnut growers. However, given the superior selling margin of the snack foods business, the company has been aggressively moving into that space, mostly through its acquisitions of the Pop Secret and Kettle Brand franchises in 2008 and 2010, respectively. As a result, the company was able to increase its revenue base by more than 50% over the past four fiscal years, despite a challenging selling environment in its nuts segment.

Unfortunately, Diamond Foods' profit growth trajectory has not matched its top-line trajectory over that time period due to a decline in its adjusted operating profitability, as illustrated in the below table. While the company's gross margin in FY2013 was comparable to that of FY2009, its operating profitability sunk by roughly 490 basis points due to the aforementioned rise in compliance costs as well as a need to increasingly spend on product development and marketing initiatives in order to stay on top of mind in the highly competitive snack foods business.

FY2013 FY2012 FY2011 FY2010 FY2009
Sales $864 M $981 M $967 M $682 M $571 M
Adj. Operating Income $27 M $29 M $74 M $47 M $46 M
Adj. Operating Margin 3.1% 2.9% 7.6% 6.8% 8.0%

Source: Diamond Foods 2013 10K Report

In FY2014, though, it looks like Diamond Foods may have turned a corner, reporting a 100 basis point improvement in its adjusted operating profitability, a positive trend that led to a 9.8% increase in its operating income. While the company's nut segment continued to back pedal during the period, posting a 17.3% decrease in segment profit due primarily to a double-digit drop in sales, the segment's negative performance was more than offset by a sharp profit gain for its snacks segment, which benefited from a 7.1% increase in sales that seems to have been a function of higher average prices and Diamond Foods' ability to increase the size and productivity of its distribution network. More importantly, management expects the positive vibe to continue for the remainder of the current year, as it forecasts a year-over-year increase in adjusted operating income.

The sector is getting crowded

Of course, whether or not Diamond Foods will be able to deliver on management's projections is up for debate, especially given the rising level of competition in the so-called "better-for-you" area of the snacks business in which the company competes. Boulder Brands, for one, has built a major presence in the space, offering a wide variety of snack foods products, mostly under its Udi's and Glutino brand names that focus on gluten-free offerings. The rising popularity of the company's products has allowed it to capture more distribution points in the grocery industry, a favorable trend that has led to strong sales growth for the company, up 92.6% over the past four fiscal years. More importantly, Boulder Brands' increasingly larger scale of operations has created production efficiencies in its operations that have positively impacted its operating profitability over that time period, providing funds to further invest in product development and even more diversification of its product portfolio.

Likewise, the snacks business is a major focal point for Hain Celestial Group (NASDAQ: HAIN), which enjoys a strong position in the space with its Garden of Eatin' and Terra brands. Similar to Boulder Brands, Hain Celestial Group has benefited over the past few years from a consistently larger distribution footprint in the grocery industry, as well as the positive effects of its acquisition-heavy strategy, which has helped to spur a 142.0% increase in its top-line over the past four fiscal years. Not surprisingly, the higher sales tallies have led to rising profit growth for the company over that time period, providing the fuel for a continuation of its growth-by-acquisition mindset, highlighted by its recent purchase of Tilda's, an acquisition that moved the company into the basmati rice category and positions it for greater sales in rice consuming regions, like India.

The bottom line

The market seems to like the business developments at Diamond Foods, bidding the company's stock price up by almost 20% over the past twelve months, despite some recent price weakness caused by lower than expected profitability in Diamond Foods' latest quarterly report. That being said, Diamond Foods still seems to be a fairly risky proposition, given that its nuts segment, accounting for almost half of its sales, continues to be stuck in a downtrend, negatively impacting the company's overall growth rate. Until the company is able to drive profit growth from both sides of its business, a seemingly unlikely event in the near term, investors should probably stay away from this work in process.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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