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Author: bcs123 Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 21503  
Subject: DMND & the anatomy of a fraud Date: 11/23/2011 12:23 PM
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This Diamond Foods (DMND) situation is really interesting, looks like a fairly basic fraud that is now unraveling.

A brief review:
Diamond Foods was a collective of walnut growers in California that went public in 2004. The company mainly sold walnuts in various forms for snacks and cooking. They launched the Emerald Nuts brand in 2004 and have aggressively grown it since then by paying very high slotting fees (there are placement fees to supermarkets).

The company was showing decent earnings growth in 2006-2008 period, and then in 2009-2010, the company made two acquisitions of snack food brands: they bought Pop Secret from General Mills for $193m in August 2008 and they bought Kettle (potato chips) from a private equity firm for $691m in March 2010. In both cases, they paid very high multiples and in the latter used cash raised from selling stock. They showed nice smooth earnings growth throughout this period.

In April 2011, the company announced that via a Reverse Morris Trust acquisition they were going to acquire Pringles from Procter & Gamble (PG). Before the deal, DMND had 23m diluted shares and $487m net debt. As part of the deal, they would issue 29m shares and up to $1.05b debt (depending on DMND stock price, about $60/share at the time). This was a huge deal for DMND; it was buying a company almost twice its own size. PG had been looking to get out of the food business for awhile, Pringles is basically no growth, and this deal enabled PG to offload Pringles without having to pay any taxes. Based on DMND's share price at the time, it looked like the multiple was about 12-13x EBIT. Initially upon deal announcement, DMND announced there would be $100m in merger costs, a number that seems fairly high.

I had looked at DMND as a short a few years back at about $30/share as something seemed a little weird about their numbers, the organic growth was much lower than the company claimed, and the multiple paid for the acquisitions was higher than the company claimed. I ultimately passed because the acquired brands were pretty solid and the downside on DMND seemed not that great.

Forward to this summer. The market got excited about the Pringles deal as they believed it was going to transform DMND into the #2 snack player to Pepsi, and the stock went to $90/share.

Off Wall Street, a research firm that focuses on short-selling, put out a report on DMND in September 2011. They claimed that DMND had been manipulating the amount and timing of payments to walnut growers in order to pump up earnings, and that the company then used these smooth earnings and resulting expensive share price to issue stock and buy solid snack companies.

Here is the alleged mechanism:
Remember, that DMND went public in 2004 and had previously been a collective of walnut growers. As part of this transaction, DMND signed long term contracts (2-10 years) with walnut growers to buy their production, with DMND getting unusual leeway into determining the prices paid. DMND's fiscal year ends on July 31, 2011. Apparently, DMND had been low-balling the walnut growers over the years, and this past year they really stiffed them, and as a result a number of the growers were furious. Then in September, after 2011 fiscal year end, DMND sent a big payment to growers, estimated at up to $70m. There is debate over the nature of this payment. To some, DMND called this a "momentum payment" for the upcoming 2012 year. Other growers have said that DMND explicitly noted in some contracts that this was a catch-up payment for the 2011 year. Skeptics have argued that DMND illegally shifted a huge payment from 2011 to 2012 in order to massively puff up 2011 earnings and enable the Pringles deal to go through. Instead of DMND doign $93m EBIT in 2011, the real number should have been something like $20m. Interestingly, a few months after the Pringles deal was announced, DMND quietly raised their merger integration expenses number from $100m to $150m. Note the similarity to the Olympus events, stuffing losses into acquisitions.

A number of outlets picked up on the Off Wall Street allegations, with both the Wall Street Journal and Barron's running pieces in October. On November 1, DMND issued a press release saying they were delaying the close of the Pringles deal from mid December 2011 to the first half of 2012 and launching an internal investigation of the allegations made regarding the walnut payments.

The stock traded off sharply over this period, dropping down to about $35/share this week.

Last Thursday, November 17, the company filed a press release titled, "In Remembrance of Joseph P. Silveira", saying that Silveira, a long-time board member, had passed away. The press release did not mention cause of death.

Yesterday, reports came out yesterday that Silveira, age 62 and one of three members of the audit committee, committed suicide by shooting himself in the head. The stock opened today at $29/share.

I look at a lot of shorts, and I find that in many cases where people suspect fraud the allegations are pretty trumped up. There are often legitimate reasons (perhaps unwise, but legitimate) why a company builds working capital or changes reserves or makes certain acquisitions. DMND looks like the real deal. It seems they were pumping up earnings through a fairly straightforward mechanism, then using the expensive stock to assist them in making acquisitions that made them like a "growth" company. Perhaps most importantly, they had an escape plan; Pringles was the ripcord and they would be pretty easily able to stuff the previous expenses into that deal without attracting much attention. Walnuts are yesterday's news, pass me some Pork Braised Pringles.

And they would have gotten away with it, if it hadn't been for those meddling kids. Hat tip to Off Wall Street, who appear to have really nailed this one.
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