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Diamond Foods A Buy Despite Lingering Effects Of Accounting Scandal

|Includes: Diamond Foods, Inc. (DMND)

Diamond Foods' (NASDAQ: DMND) recovery on the stock market is proving more elusive than an arch fugitive. The stock is trading at around $28 a share (at the time of writing). This is a far cry from the highs of $90 in 2011, the year it was accused by the Securities and Exchange Commission (SEC) of artificially inflating earnings.

The SEC alleged that Diamond Foods former Chief Financial Officer, Steven Neil, had crafted a scheme to misrepresent earnings. Neil allegedly underreported how much money the company paid walnut growers by pushing the recording of the payments into later fiscal periods. This, by the SEC's explanation, allowed the company to artificially inflate its reported earnings.

Slow Turnaround

Diamond Foods has however put the accounting scandal behind it and is aggressively pursuing a turnaround. Diamond Foods' fourth quarter earnings, which were reported in September, indicate that net sales at the company's snacks segment increased 11.1 percent year over year to $130.1 million. Net sales in the Nuts segment improved 7.5 percent year-over-year to $88.9 million. This led to improved distribution and market share gains at both the nut and snack segments. Despite the top line improvements in the fourth quarter, the firm's margins declined.Gross profit for the quarter decreased 7.2 percent year over year to $49.3 million, from $53.1 million in the fourth quarter of fiscal 2014.

'Post Scandal Syndrome'

The recent increase in Diamond Foods' top-line affirms that the decline in the company's margins is not attributable to poorly performing brands, but something else. As put forth in Diamond Foods earnings report, high costs, specifically logistic costs, were to blame for the broad decline in margins in major segments over the fourth quarter. Interestingly, Diamond Foods' high costs were not necessarily problems, but symptoms of a greater underlying problem.

The underlying problem is the low, but improving, trust from investors. The company is suffering from 'post scandal syndrome'. It is still reeling from the effects of the accounting scandal.

How does low investor trust inflate costs?

Investors generally take time before they forgive the sins of a company, especially alleged financial fraud. This is strongly suggested by the sharp decline and subsequent prolonged stagnation (as shown in this interactive chart) in Diamond Foods' share price at the wake of the 2011 scandal. The stagnation in Diamond Foods' share price over the past several years has greatly compromised its ability to raise finance through the equity markets. This has hamstrung its turnaround bid by limiting the firm's ability to lower its costs. This is not only because using debt as a means of finance is costlier, but because the permanent solution to lowering costs, especially logistics costs, is increasing size to attract economies of scale; and this requires heavy financing.

Courting scale has worked well for some of Diamond Foods' bigger competitors in the snack segment, including Boulder Brands (NASDAQ: BDBD). Boulder Brands' comparatively larger size has availed scale efficiencies in its operations, positively impacting its profitability and providing finances for further product development.

Diamond Foods however cannot raise reasonable finances requisite for expansion through the equity market. This is because the damaged (but recovering) investor confidence makes it hard for its share price to rise. If the snack maker continues improving sales and corporate governance, it could inspire an attitudinal change among investors, leading to steady gains in its shares. This could then allow it to finance expansion, allowing it to lower its costs. The current suppressed share price, coupled with the prospect for improved sales, makes Diamond Foods a good long-term opportunity. Still, we need to see stronger investor confidence.

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