Diamond Foods' Potential Upside Significantly Outweighs The Potential Downside

| About: Diamond Foods, (DMND)
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As an investor who prides himself on contrarian thinking, I am always compelled by the stocks that are the most heavily shorted. Earlier this year it was Skullcandy (SKUL), with a short float ratio that exceeded 60% of the float. It has since turned around sharply off the lows. Last week it was SuperValu (SVU), and traders of this stock witnessed a sharp short squeeze on what would have normally been a modest move based on a slightly positive earnings beat. At last count, on March 30th, the short ratio for Diamond Foods (DMND) was hovering around 50%, down 6.3% from the last official reading released 2 weeks prior. While this count was from about 2 weeks ago, it does not appear that many of the shorts have covered. Since then the stock has dropped nearly 10%.

Aside from the obvious issues about the improperly accounted for payments to walnut growers and the associated SEC investigation, there are a number of other factors that are negatively impacting the stock price of Diamond Foods in the past few weeks. Accordingly, a stock trading at an already significantly depressed $23-$26 range is now down to the $20 range based on these 3 factors.

Firstly, there is a major liquidity issue with the stock. Internet chatter is suggesting that many brokers, including HSBC (HBC), E-Trade (ETFC) and Saxo are not accepting margins on the name. This alleviates much of the usual buying pressure from traders that play the pops in distressed stocks. I am one of those traders, and I use margin to gain leverage for this particular sort of trade. For a stock that is trading only about 500,000 shares per day recently, this is a major price depressing factor.

Secondly, and even more damning to the share price, is that there are no clear catalysts seen until June 11th. This is the date that Diamond Foods has stated by which they will release their restated earnings. Traders, being a short-sighted group, have been abandoning the name for no other reason than the fact that they do not want to tie up their funds in a company that may just very well drift downward or sideways into earnings. Couple this with the low volumes and lack of margin and it becomes pretty clear why this name has fallen out of favor among those looking to capitalize upon upside volatility.

Finally, while there is no direct evidence to prove this, it is clearly advantageous to potential private equity or other suitors to depress the stock price as much as possible during any ongoing negotiations. Of course, a rapidly falling stock price, as in the case of Diamond Foods as of late, can spark urgency concerns with regards to expediting any potential deal. Also, the current traded market value of the company is a major factor when determining the valuation of the potential investment. With the low float and artificially lower trading volumes, keeping the share price of Diamond Foods down is a relatively easy task for any group with significant enough resources to be in negotiations with Diamond Foods to begin with.

However, all is not lost for Diamond Foods. In fact, the future of the brands that the company owns and markets has never been brighter and more prosperous. Furthermore, if recent industry consolidation and acquisitions are any indication, there is tremendous value to be unlocked for those that can look at the bigger picture that is slowly but surely unfolding.

On March 13th, the company released a brand performance update. Based on U.S. Nielson retail scanner performance data for the twelve-week period ending February 18th, it is proven that Diamond Food's unique brands continue to outperform their respective product categories. Leading the charge is Emerald, the company's snack nut brand, with YOY growth of 29% compared to 2% category growth. Emerald recorded an overall market share increase of 2% during this period. Pop Secret and Kettle also both gained significant market share and significantly outperformed their product categories. One mild disappointment, however, due to the macro effects of a sharply increased Asian demand for walnuts, is that Diamond of California, the culinary nut brand, lost 0.3% market share due to decreased supply as price hikes have compelled many walnut growers to sell abroad in order to feed that new demand.

Following the release of this data, the market was initially encouraged by the results and the shares rallied, albeit to a muted reaction. In a research note to clients that morning, D.A. Davidson analyst Timothy Ramey, who currently has a Buy rating on the stock, said "The bottom line here is that Diamond Foods' underlying business is doing well - accelerating growth and gaining market share - while the stock remains distressed."

A few days later, on March 21st, during a period of relatively light trading volume, Diamond Foods stock suddenly spiked under heavy volume on rumors of a private equity investment. The Wall Street Journal reported that according to persons familiar with the matter, Dean Bradley Osborne Partners, the investment bank hired by Diamond Foods to explore capital raising alternatives, has approached KKR (KKR), TPG and Blackstone Group (BX) to gauge their interest in taking a minority stake in the company. This news caused a short-lived but powerful short covering frenzy that lifted the stock by as much as 15% in a few minutes near the close of trading, before settling up 2.4% for the day.

What this demonstrated to me, more than anything, was the power of the short squeeze potential in this name. Followers of Diamond Foods will surely remember the 53% upwards move on over 15 million share volume on December 9th. On this day, KeyBanc analyst Akshay Jagsdale released a research note stating that he believed that the internal audit investigation will end favorably (it did not), and that the risks are overstated (they were not). On that day I went short into the close, as I am a seller of hype and speculation. I was rewarded greatly during the next trading session when it gave back most of its gains after the market had the weekend to digest the move and the stock price came back down to earth.

With all of that said, this is a stock of great extremes. Overvalued in the $40s, as it implies a perfect pricing of the company, but severely undervalued at $20.84, the most recent closing price on April 13th. When reiterating his $44 price target and Buy rating on Diamond Foods on March 13th, Timothy Ramey said that the Kettle division alone could fetch up to $900 million in a sale. Whereby estimating the current debt in a worst-case scenario to be upwards of $600 million and a company market cap of just $460 million, clearly there is a huge opportunity here for strong-willed value investors. Even the most bearish analyst, Mitchell Pinheiro from Janney Capital, has Diamond Foods rated as a Neutral with $23 price target worth $31 in a breakup scenario. This would represent nearly a 50% premium from Friday's close. Also worth noting is that no analyst that covers Diamond Foods has a Sell rating on the stock.

Finally, the demand for consumer growth brands, particularly in the snack food category, has never been stronger. Large conglomerates are struggling to compete with PepsiCo's (PEP) overwhelming dominance in this sector. Kellogg (NYSE:K) CEO John Bryant told Reuters that Diamond Food's is "clearly a fit" for the cereal maker on February 15th. This comment followed Kellogg's acquisition of iconic chip brand Pringles on the same day. Although accounting has not been Diamond Food's strong suit, brand marketing and management has always been what they excelled at. This is evidenced by the rapidly growing market share of their key brands. Furthermore, growth brands are hard to come by these days in the rapidly growing snack food category, especially when companies like Kellogg, Kraft (KFT), and Snyder's-Lance are stuck playing catch-up down at least a few laps to PepsiCo Frito-Lay. So, from a valuation and cash flow standpoint, the brands are clearly attractive to private equity. However, from a growth standpoint, the brands are a necessity to the large conglomerates who are literally starved for growth and sitting on mountains of cash.

In summary, as a deep-value investor who prides himself on contrarian thought, Diamond Foods appears to have set the stage to be a very compelling play. Certainly at this time, my opinion is that the potential upside significantly outweighs the potential downside and we have already seen a few cases of empirical evidence that proves that the stock is prone to quick and significant short covering rallies based on little more than rumors, opinions and innuendo. This is a classic Risk vs. Reward scenario, where the odds are now sharply favoring a near-term upside share price appreciation by June, barring any disastrous turn of events that may derail Diamond Foods completely. However, if history is any indication, the new interim CEO, Rick Wolford, has just recently hammered home a multi-billion dollar deal involving the same private equity groups that he is now courting for investment into Diamond Foods. I have placed my bets, and will continue to add to them on further weakness in the share price.

Disclosure: I am long DMND.