Diamond Foods Inc (NASDAQ: DMND) is a packaged food company which has grown from an agricultural cooperative focused on nuts into a serial acquirer of branded food products, including the 2008 purchase of Pop Secret microwave popcorn, 2010 acquisition of Kettle Foods potato chips. The most recent transaction was announced earlier this year, whereby DMND would purchase Pringles chips from Proctor & Gamble (NYSE: PG), transforming it into the second largest snack company in the world and diversifying the company’s operations away from the swings in commodity prices for nuts. Despite these high profile acquisitions the company has fallen on tough times, losing nearly 60% of its value since the beginning of the month. The company now trades at a P/B of 1.35 despite strong revenue and earnings growth throughout the recession and (seemingly) strong and improving margins. What gives? Is this decline justified?
The company’s troubles began in late September, when the Wall Street Journal published Hidden Flaw in P&G’s Diamond Deal, an article critical of some payments that Diamond had made to walnut growers:
Diamond uses multi-year contracts that allow it to set walnut prices unilaterally—a practice that is causing uproar among growers.
As walnut prices surged for the 2010 crop, Diamond paid growers much less than most buyers, according to several growers interviewed by The Wall Street Journal. And yet on September 2, Diamond made an extra “momentum” payment to growers they hadn’t received in past years. The payment sizes varied, but averaged 25 cents a pound or more, growers say. By email, Diamond says: “In an effort to optimize cash flow for growers, particularly in light of the delayed harvest, we issued a momentum payment to growers that provides additional cash flow in the fall consistent with the current market environment as we enter the 2011 harvest.”
… Pressure from growers could quickly become an issue for Diamond. After all, growers can go elsewhere when contracts expire and exports to places like China and Turkey have been surging.
At first glance, this might seem like a reasonable explanation. DMND exerts significant power in its relationship with its suppliers. Companies in this position must balance their short term and long term interests. In the short term, using this negotiating power to pummel suppliers and increase profits might be attractive, but this can lead to long-term instability as suppliers become financially weakened and any goodwill is destroyed, resulting in a precarious relationship that could collapse at any point. Here, DMND is saying that it wants to ensure that its suppliers are around (and willing to supply DMND rather than overseas buyers) for the 2011 harvest, and so it was helping out with a “momentum payment.”
While this sounds reasonable, it is important to recognize this as a big red flag. Anytime companies make extraordinary payments to suppliers, there is an increased likelihood of financial shenanigans being used to shift expenses and cash flows between periods to manipulate the appearance of the company’s financial statements (Read Financial Shenanigans or my in-depth review to learn more). Moreover, according to this article the payments are even stranger than they first appear (emphasis added):
Some growers said the total payment for the prior year’s crop left them underpaid relative to market rates for walnuts, fueling speculation that Diamond tried to shift its payment to its current fiscal year and to make the prior year’s results look better. Some growers also apparently received the September payment even though they don’t plan to supply Diamond walnuts for the upcoming year.
The bizarre nature of these payments and the red flag for financial shenanigans calls into question the validity of previously presented financial statements. In my books, this makes the company unfit for investment. How can you ever get comfortable with an analysis based on financials that cannot be trusted? There is rarely one cockroach in the kitchen, and there is no price that would make me want to be exposed when others are uncovered. In case you thought these payments weren’t material to the company’s operations, the WSJ article clears this up:
That payment is critical to investors because it would have made a big dent in Diamond’s earnings had it been made by July 31, when the company’s fiscal year ended. The company declined to specify the size of the payment, but it’s possible to make a decent estimate. According to the Department of Agriculture, one billion pounds of California walnuts were sold in the 2010 crop. Diamond disclosed that in 2005 it bought 283 million pounds of walnuts, or about 40% of California’s production. So conservatively assuming it bought 20% of 2010′s output, the momentum payments would total $50 million. That compares with $93 million in operating income for the entire fiscal year.
On November 1st the company announced that the closing of the Pringles deal would be delayed until sometime in 1H 2012 (rather than an original Dec 2011 close). The delay is the result of an internal investigation into the walnut payments:
Diamond and P&G have revised the expected closing date of the acquisition following the receipt by the Chairman of the Audit Committee of Diamond’s Board of Directors of an external communication regarding Diamond’s accounting for certain crop payments to walnut growers. In response to the communication, Diamond’s Audit Committee decided to perform an investigation of this matter. Management is fully committed to supporting the Audit Committee in this process.
The story then takes a turn for the tragic. On November 17th, Joseph Silveira, a director of DMND died. It wasn’t until November 23rd that it was revealed that he died as a result of suicide and that he was a member of the company’s audit committee. The company says, as a walnut grower himself, he had recused himself from the investigation into the momentum payments. The market reacted poorly to the news, sending shares down another 20.5%.
This controversy has some important implications, including potentially killing the Pringles deal. This deal was set up such that DMND would issue 29.1 million shares an assume a level of debt that ranged from between $700 – 1050 million, depending on the (VWAP) average price of DMND leading up to the closing of the transaction (essentially creating a collar on the value of the deal for PG shareholders). Any price less than $44.61 results in the high end of debt being assumed, so with a share price now in the $27.70 range PG shareholders are getting a much worse deal than originally contemplated (to the tune of approximately $490 million, or 21% of the announced transaction value). According to the proxy statement, PG has the right to terminate the transaction if DMND breaches any of its representations and warranties or covenants, potentially giving PG an opportunity to exit or renegotiate the deal. This introduces a significant amount of uncertainty when attempting to get a handle on what DMND will look like a year from now.
The consequence is that in analyzing DMND, one must consider two scenarios: one for the Pringles deal occurring and one for it being scuttled. In the event that the deal is scuttled, I don’t think even the current depressed purchase price is attractive on a free cash flow basis, even when not adjusting for the delayed payments. Furthermore, the company maintains an unattractive level of debt and its historical returns are lackluster at best. If the deal does go through and the high range of debt is assumed, based on the historical combined financials found in the proxy statement (which again paint an overly attractive picture given the shenanigans), I am also less than impressed.
So despite a dramatic decline in the company’s share price, I don’t find DMND to be an attractive purchase, even if the apparent shenanigans can be explained satisfactorily (which I doubt).
What do you think of DMND?
Author Disclosure: No position.