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No. of Recommendations: 18
Hi all,

DMND has been a falling knife. The stock traded north of $90 per share in September, 2011 and it has fallen to a mere $23.52 per share as I write this. My expectation is that after a 75% haircut in the price per share there would be a high probability that Mr. Market may have created a bargain. I’ve attempted to find out, as best as I can, and I share the highlights of what I’ve learned in the following – my primary objective being to assign a fair value to the shares that I’m reasonably confident in.

The reason for the sell off has been some confessed financial reporting shenanigans concerning the timing of certain expenses. It appears that the now ousted CEO and CFO cooked the books so as to goose reported earnings:

http://investor.diamondfoods.com/phoenix.zhtml?c=189398&...

The admitted sin: The Audit Committee has concluded that a "continuity" payment made to growers in August 2010 of approximately $20 million and a "momentum" payment made to growers in September 2011 of approximately $60 million were not accounted for in the correct periods, and the Audit Committee identified material weaknesses in the Company's internal control over financial reporting.

In what follows I’ve assumed that the audit committee’s work has been thorough and complete and that there are no other skeletons in the closet – an assumption that may prove incorrect. The offending CEO and CFO have been ousted, rightly so, and I’m at least willing to entertain the idea that the company can work their way through the consequences of this unfortunate and stupid act by former management. I am impressed by how quickly the board acted in removing a CEO who had long held that post. An SEC investigation of the incident, fines and shareholder lawsuits can be expected.

It should be noted that short sellers have sold about 50% of the float short as of January, 2011. So, there’s a lot of money betting that an even lower stock price lies ahead. Given the improprieties and uncertainty surrounding the shares their pessimism is probably warranted. Another shoe may drop.

I attempted to use one of Professor Damodaran’s spreadsheets to value the shares after making certain adjustments to the financial statements. The adjustments included correcting for the improper timing of expenses and also stripped out one-time acquisition expenditures to arrive at a financial picture indicative of the consolidated business as it currently stands and will likely be going forward. The end result is that I calculated a range of fair values for the stock, depending on various assumptions, of between $19 and $35 per share and, as is often the case, obtained absolutely no confidence in these numbers due to their sensitivity to minor changes in the inputs.

To gain more confidence in my assigned value to the shares and to also narrow the range of values to something more useful, I elected to follow an appraisal approach comparing key valuation metrics of DMND with a few of its peers in the Processed & Packaged Goods industry. The key metrics I chose to concentrate on are:

* Enterprise Value / Revenue
* Net Profit Margin
* Debt / Equity
* Historical revenue growth rate

Because the profitability of DMND is in some doubt due to the expense reporting shenanigans, I believe it reasonable and prudent to view their profit margins with some skepticism and that is why I chose the EV/Revenue metric. DMND has a large amount of debt and I believe that can play a role in determining the fair value for the equity. Growth is of course an important determinant to assigning a fair value multiple.

According to Prof Dam’s website, the average EV/Revenue for the food industry is 1.08x. In general, higher multiples are given to businesses with better than average profitability and/or growth rates.

Some DMND history is important to the appraisal process. Originally founded by a group of walnut growers, DMND primarily supplied walnuts and other nut products to grocery stores as a cooking ingredient. They later launched the Emerald brand of nut snack treats.

In September 2008 they acquired the Pop Secret popcorn brand from General Mills for $190 million in cash (funded by debt) and the brand was expected to add $85 to $90 million in sales in the coming year. They paid 2.11x revenue for this brand which commands a 25% share of the microwave popcorn market.

In the few years prior to this acquisition, DMND showed meager profitability capable of producing net margins of only 1.5%. Revenue growth rates struggled below 3% per year.

After the Pop Secret acquisition, the net margin of the consolidated company improved to around 4%. And, reported growth rates were much higher due to that acquisition – for a year anyway.

In March 2010 DMND acquired Kettle Foods (chips) from Lion Capital for $615 million in cash (funded by debt). At the time of the acquisition, Kettle was expected to add $250 million in revenue and double the company’s EBITDA. They paid 2.45x sales for the Kettle brand and net margins improved to in excess of 5.5% although the expense “shifting” by management played a role in this margin improvement.

Fwiw, I think these two acquisitions were good ones. They allowed DMND to gain shelf space in the grocery “snack” aisle and leverage its legacy nut business by moving more so into that higher margin aisle compared with the lower margin cooking aisle. The reported results seem to suggest that they were successful in doing this.

In April, 2011 DMND announced that they were acquiring the Pringles potato chip brand from P&G in an all-stock transaction valued at $2.35 billion. The Pringles brand has world wide sales of $2.4 billion and its acquisition would vault DMND into the number two snack food company behind only Pepsi’s Frito Lay. Unfortunately, a consequence of the former CEO’s book-cooking shenanigans is that P&G will most likely walk away from this deal due to a material change in DMND’s finances as a result of those shenanigans. For my purposes this deal does provide two key pieces of information: another valuation point, Pringles could be had for about 1.0x sales; and the all-stock nature of the deal may suggest that DMND stock was overvalued at that time. In April, 2011 DMND shares were trading hands at about $60 per share. At that $60 price, DMND’s EV to revenue multiple was about 1.9x. At the $90 per share high price, DMND’s EV to revenue multiple was about 2.6x.

DMND has $530 million of secured debt and that debt has first claim on virtually all the assets (tangible and intangible) that the company owns. Total assets are $1.3B but goodwill and intangibles account for $0.87B of this total. In a bankruptcy scenario, it appears shareholders would be left with nothing as the net tangible asset value is less than the debt owed.

Having rambled on long enough to lose most readers, I’ll get to the meat. Here are DMND’s metrics along with the supporting data:

DMND:
Enterprise Value ($ millions):
Long Term Debt (4/30/2011) 530.7
Shares Outstanding 22.0
Quote Per Share 23.52
Enterprise Value 1048.1
Revenue (ttm ending 4/20/2011) 966.0
EV / Revenue 1.09
Debt / Equity 1.03
Net Profit Margin (3-yr Avg, as reported) 5.5% Excludes Acquisition Expenses
Net Profit Margin (3-yr Avg, adjusted) 3.2% Excludes Acquisition Expenses
Revenue Growth (5-yr Avg) 15.2%


And, for the comparable companies I’ve chosen in order of increasing Debt/Equity ratio:

Peers:                                      FLO    CPO    THS
EV / Revenue 1.08 0.97 1.51
Debt / Equity 0.38 0.9 0.95
Net Profit Margin (3-yr Avg, as reported) 5.1% 3.9% 4.1%
Revenue Growth (5-yr Avg) 8.5% 13.1% 20.8%


I’ve selected these three companies because they show net margins similar to that of DMND’s. You’ll also note that DMND’s 5-year historical revenue growth of 15% is bracketed by these comparable companies too.
I own FLO shares and they are a well run company that historically has grown by acquisitions just as DMND has done in recent years. FLO’s current debt level is relatively high, for it, having just completed a series of acquisitions and the expectation is that they will pay that debt down over the course of the next few years. I’m also confident in saying that I think FLO is about fairly and fully valued at its current price.

My assessment of DMND’s situation is that their acquisition activity will come to a screeching halt for the foreseeable future because their credit lines are nearly tapped out. Their stock is no longer ample currency on which to do a deal with. So, my expectation is that near term future growth will be limited by what can be achieved from reinvested earnings, alone. Their payout ratio is only about 8% as they pay a tiny dividend amounting to about $3.5 million per year.

If all goes well and there exists still untapped synergies from the recent acquisitions, DMND will do well to grow in the 8.5% to 13.1% range exhibited by FLO and CPO. This would suggest a fair value EV to revenue multiple of 1.0x is about the best that can be hoped for.

Based on this, it is my opinion that $25 per share is fair for DMND.

Another way to look at the fair value is to utilize the acquisition multiples for the Pop Secret and Kettle brands. To do this, I’m going to discount the sales multiple paid by an assumed premium for control of 25%. And, I’ll assign a sub-par fair value multiple of 0.8x for the legacy DMND business given its historic sub-par net margin (1.5%). This leads to the following:

DMND:              Sales  x Multiple     = EV
Legacy DMND 626 0.80 500.8
Pop Secret 90 1.58 142.2
Kettle 250 1.84 460
Total 966 1103
Debt -530
Value of Equity 573
$ Value Per Share $26.05


With that, my bottom line is that I think the fair value for the shares is in the mid-$20’s. At best, $30 per share.

I’m left to conclude that DMND stock’s big run up to $90 per share was driven by acquisition growth fueled euphoria by the market (qtr over qtr growth rates were 30%+ but it was nearly all the acquisitions and unsustainable) along with a few momentum buyers piling on to the point of no reason. The chart goes straight up starting with the Pop Secret acquisition and accelerates as time goes by. A bubble destined to pop and it did. Still, it’s hard to believe that the valuation could have gotten so out of whack. Perhaps, my valuation is too conservative and the market will one day soon prove me wrong.

Rich
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No. of Recommendations: 1
Nice post. My only quibble is, the valuation for pop secret and kettle are high. Today a prospective buyer of DMND will not pay those kind of multiples.

In any case, I would wait for the dust to settle on this one. I think the stock is not done with its declining.
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excellent post Rich. I was also considering looking at them. So thanks for the help. Did you by chance look at what moving the expense into the wrong quarters did to earnings? Have not looked at them yet, but I gather they put payments to growers into future quarters that would be masked by acquisition activity to spare the earnings in the period they should have been expensed in. Was it really necessary to resort to this? Was business that shaky?

At the very least it makes a good case study for fraudulent accounting. Always a positive
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Hi CM,


My only quibble is, the valuation for pop secret and kettle are high.


You might be right. I was maybe too generous.

I do see these two acquisitions as adding shareholder value long term. And that is my only justification for the higher multiple on those 2 brands.

Overall, I like the company and would be a buyer at a significant discount to $25 per share. Say, dip a toe in at 1/3rd off and back up the truck at 1/2 off.

Rich
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No. of Recommendations: 4
Hi Kit,


Did you by chance look at what moving the expense into the wrong quarters did to earnings?


Yes. I was working with annual data, not quarterly. The way I interpreted the confessed accounting shifting was that the $20M "continuity" payment should have been reported in the 2010 results but wasn't. So reported net income of $26.2M was really $20M less or $6.2M for that year.

For 2011, I assumed that that $20M "continuity" payment was in fact reported in that year (having been shifted from 2010). But, the $60M "momentum" was not. So, reported $50.2 million in net income becomes for 2011:

Adjusted Net Income = $50.2 million + $20 million - $60 million = $10.2M.

I'd point out that in 2011 there was $16.8M of acquisition related expenses. And, in 2010 there were $11.5M. So, I think these one-time expenses should be added back in to the net's above to give a picture of the business' true earning power.

So with all that adjusting done. EPS for 2010 was $0.94 and for 2011 $1.21,


I gather they put payments to growers into future quarters that would be masked by acquisition activity to spare the earnings in the period they should have been expensed in.


Yes, that's what it looks like.


Was it really necessary to resort to this? Was business that shaky?


I'm speculating here but the way I see it goes something like this: We have a dynamic CEO with an all stock deal pending. This deal will be a huge feather in his cap and catapult DMND on to the world stage in snacks. The success of his entire strategy hinges on this deal getting done. Because its an all stock deal based on a fixed amount of shares, the value of the deal to P&G shareholders is dependent on DMND's stock price - a bubble induced overvalued currency. If that stock price falls significantly, the value of the deal shrinks and P&G may walk away.

So, there was a large incentive for him, from an ego standpoint, to prop up the share price at least temporarily until the deal closed. Shifting expenses was a way to extend the good times just long enough to get to the original closing date.

For some reason that I don't recall, the original planned closing date got extended and the house of cards collapsed before the actual closing. That closing will probably never happen now.

The business was fine. It's just that the market's perception of it had no basis in reality and the CEO must have known this. His actions simply were an attempt to extend the fantasy a little while longer.

But, I could be all wet as there really isn't any way to know what his intentions were. We may never know.

One good lesson here for investors is that when a company announces an all stock deal, it makes sense to ask the question: "Are these shares overvalued?" And, if they are sell. Often times, all stock deals get done because the stock price is inflated.

Rich
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No. of Recommendations: 4
Funny thing about shoes, they can come from any direction:

http://finance.yahoo.com/news/Exclusive-Walnut-growers-seek-...

snips, emphasis mine.


Some California farmers plan to stop selling their walnuts to Diamond Foods Inc in the wake of an accounting scandal over grower payments that has claimed the jobs of the snack company's chief executive and chief financial officer.

Six small walnut growers told Reuters they would stop supplying Diamond when their contracts expire because they say the company has been underpaying farmers. Three of those growers said they hoped to break their contracts early.

The walnut growers Reuters spoke to said they know of more than a dozen other growers who also want to terminate their relationships with Diamond. While that is still a fraction of the roughly 1,000 growers who supply Diamond, if there is an exodus, it could hurt the company's ability to fulfill orders or force it to pay more in an increasingly competitive market.

"Their prices are just not competitive," said Guy Harris, whose family has sold walnuts to Diamond for 45 years. "In 2010, they were 25 percent below a lot of other buyers."

Harris, who sells about 400 tons of walnuts every year and owns Diamond shares, said he will not renew his contract when it expires later in February. He said he knew of at least three other growers who were looking to exit their contracts.


Something like this could negatively and permanently impact the fair value.

Rich
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Funny thing about shoes, they can come from any direction:

I think "cockroach theory" fits these kind of situations very well. There is never 1 cockroach, similarly when you see fraud, especially at the top, there are many more by the underlings. It will take sometime for the new management to come and clean the house. And you will have few bad quarters, where the management has to throw the kitchen sink and low ball the expectations what else and what not.

That's when the pessimissm will be highest and the stock will not be touched by anyone, offerring a great opportunity. The question at that point is whether one can hold his nose and buy some.

We can revisit this may be after 3 months?
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Some concluding remarks on DMND:

Early on in my never ending investing learning curve, I read Lynch’s books. One take-away I had was that it was important to sample a prospective investment’s products or services. Lynch, as you probably know, advocated buying shares of those companies whose products or services that you liked. It is in that vain that I give this critique of the Kettle brand potato chips. (Pop Secret I’ve purchased countless times before and so a sampling was unnecessary. The same goes for Diamond’s nut offerings.)

Yesterday I made a trip to the two grocery stores we frequent most, both are owned by Spartan Stores (SPTN). The smaller of the two, a Family Fare store, and the one I frequent most because of its smaller size did not carry the Kettle brand of chips. The much larger D&W did.

The chip aisle of course is dominated by the Frito Lay brand offerings. Near one end of the aisle, with chips stacked 4 shelves high, furthest from the checkout lanes was a small sliver of shelf space devoted to the Kettle brand only 3 bag widths wide. I had to look carefully to find them.

Only three flavors were offered; Sea Salt, Barbeque, plus Sour Cream and Onion (Kettle makes 11 different flavors according to the website). The color of the packaging I can only characterize as “drab” in stark contrast to the bright and vibrant colors of competing products. I wonder if this color choice is intentional or a marketing snafu. Sea Salt is packaged in a medium brown bag. The Barbeque chips are in an orange-red bag. And, the Sour Cream and Onion chips are in a medium green colored bag. I purchased the Sea Salt flavor for taste-testing during lunch.

A bag was offered for $3.89 and contains only 5.5 ounces. This is about the same price as a Lays bag but it is less than 1/2 the size.

The Kettle chip is thicker and crunchier than a Lays chip and greasier too. I’m reminded of the years of conditioning I’ve had over my lifetime from countless TV commercials advocating the “thin” and “lightness” of the Lays chip. The Kettle chip contrasts with this advertising induced preference greatly.

I ate roughly 1/2 the bag with my 2 peanut butter sandwiches and then offered the rest to my daughter, son and wife. The two ladies had one chip each and gave favorable but lukewarm reviews. My teenage son was more positive as he devoured the whole bag but, like Mikey, he eats everything. For myself, I doubt whether I’d purchase them again. But if they were placed in front of me and I had no other choices I would eat them – not exactly a ringing endorsement.

I’m sure there’s a whole bunch of chip contrarians in the world that would enjoy Kettle chips. Unfortunately, I’m not one of them.

Rich
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Their Salt and Pepper chips are highly addictive!!

one of the best chips on the market and sold at Costco in giant bags that still manage to disappear in rapid fashion in our household.

We like the Sea Salt ones as well. Interestingly, they are among the chips sold in a couple of health food stores in my parts.

I like 'em!

carver
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Thank you, Rich, for your careful analysis of DMND. I have been wondering about this DMND debacle and whether it is an opportunity for bottom feeding but I don't have the expertise to break out the numbers as you so well, so I am grateful. I do see in our Cincinnati papers that P & G is being coy about the DMND deal but haven't said 'Nay', so we shall have to wait and see on that.

I have concerns about your Kettle Chip taste analysis,though! Our family is totally committed to Kettle chips--they are natural and tasty. The charming low key packaging (did you say 'drab'?) is indicative of its 'natural' and 'organic' niche, and probably of the Pacific Northwest mystique where they are headquartered. Of course they aren't like Frito-Lays which I grew up with and thus might require an acquired taste but we do love their flavors, naturalness and crunchiness with beer, cocktails and sandwiches and we buy our share of them (at Costco and Kroger). I think they may be positioned for the 'urban' 'light' snacker, or what we used to call 'yuppies' way back, not the serious potato chip cruncher who likes quantity (like my husband).

I just looked on the Kettle website, by the way, and they have a nice online shopping page where you can buy any of their chips by the bundle if your local store doesn't stock the wide range and if you're up to paying the shipping.

I really like the Diamond brand nuts too. Both for baking and the snackers. I was sorry to read in a link here that the Walnut farmers are complaining about the price Diamond pays for nuts and are reluctant to resign with them due to pricing--I wonder why they signed such contracts if they thought they could do better elsewhere. Of course, if they won't sell to DMND, then they can try to sell to others, but I imagine other distributors won't be inclined to pay high prices if they detect a glut on the market. More fall-out to analyze, I guess.

Nevertheless, I am glad you posted your numbers along with projections. I am keen to watch this stock and buy at a value point and I will watch this thread for more analysis.

j.
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Thank you both carver1963 and 3Fairfield,

To learn that there are such avid Kettle Chip fans out there is valuable investment knowledge. I believe that I may have underestimated the power of this brand. I truly love reading testimonials like those that you've shared.

I'm making it a point to locate and purchase a bag of Kettle's Sea Salt & Vinegar chips. As a boy, I remember going to the county fair every year and buying French fries and pouring vinegar on them. Yum, yum. I can taste them now. Anyway, I suspect that I'd like these flavored chips better than the plain Sea Salt I tried.

Rich
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Kettle chips are an acquired taste. There are enthusiastic fans who like the hardness and greasiness of the chips. It is sort of like beer, some people like ones that taste more bitter.
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