Follow the bouncing walnut, investors. Diamond Foods‘ (NASDAQ:DMND) stock has taken us for a crazy ride for months, ever since the scandal surrounding its accounting practices broke in The Wall Street Journal on Sept. 27.
A few days after the report, Diamond’s stock dropped 10%. A month passed without ado, then on Nov. 1, Diamond announced a massive deal to buy Pringles from Procter & Gamble (NYSE:PG) was delayed until the first half of 2012 because of an investigation by its audit committee about crop payments to walnut growers. Diamond sunk 20% the next day. Ever since then, Diamond has become a trader magnet, with DMND stock seeing 10 different days of 2 million-plus volume, and the past three days have seen a 50% gain and a 25% plunge. Where this ends is anyone’s guess, but to look forward, we first have to take a glimpse back.
From Nuts to Snacks
Before its announcement in April that Diamond Foods was acquiring Pringles for $2.4 billion, few people had heard of the walnut grower. Until its IPO in 2005, Diamond Foods was a cooperative owned by northern California walnut growers with a history dating back to 1912. But the catalyst for change was current CEO Michael Mendes, who took the reins in 1997.
In 2004, Mendes put the company into the snack market by introducing Emerald nuts. In September 2008, DMND acquired General Mills‘ (NYSE:GIS) popcorn business for $190 million. Eighteen months later, it acquired premium potato chip manufacturer Kettle Foods for $615 million, putting Diamond squarely in the snack aisle of most grocery stores and in direct competition with PepsiCo‘s (NYSE:PEP) Frito Lay subsidiary.
In just a few years, Diamond had gone from sleepy walnut cooperative to a player in the snack food business with estimated revenues of more than $2.4 billion. This breakneck business pace pushed its stock from a longtime range of $15-$20 all the way to $96 in September of this year. Thus it’s difficult to believe the timing of $50 million in payments to walnut growers could so drastically alter the valuation of its stock.
The New Deal
Walnut growers voted on July 1, 2005, to approve the conversion from co-op to public company. As part of the conversion, growers received a combination of $17.3 million in cash and 8.1 million shares in the new company. The IPO states:
“After the conversion, former Diamond Growers members will be able to choose to be both an owner of our business and a supplier of walnuts, solely an owner of our business, solely a supplier of walnuts, or neither an owner nor a supplier.”
Growers that chose to continue supplying the company with walnuts signed “Walnut Purchase Agreements” of three-, five- or 10-year periods. Under the terms of the agreement they would deliver their harvest between September and November each year. Diamond then pays growers over the subsequent 15 months based on the price set by the company on March 31 of the following year, taking into account a number of factors including market conditions, quality of product, etc.
Vitally important is that the first two payments that growers receive are an estimate of the March 31 final price and therefore open to adjustment, which appears to be part of the focus in this accounting investigation. It’s a little like your hydro bill in that some months are simply estimates while others are actual readings of your meter. Suffice it to say it would be easy for both the company and growers to get a little confused.
What Does All This Mean?
It is going to take a long time to unravel this mess. Diamond said Monday its fiscal first-quarter results would be delayed slightly because the audit committee wouldn’t wrap up its investigation until mid-February, with the news sending DMND shares down 25%. This came just one trading day after Friday’s 50% jump that came after a KeyBanc analyst said the investigation would wrap up quickly and the Pringles deal would continue.
It’s easy to see why such importance is being placed on the Pringles deal. Diamond Foods gets a business global in scale with distribution to match. Currently, 58% of its revenues are in the snack category. Adding Pringles and its $1.4 billion in revenue would bump that up to 83%. Furthermore, it would go from selling 79% of its products in North America to just 54%. Pringles has manufacturing facilities in China, Malaysia, Belgium, the U.K. and Brazil, as well as several in the U.S. Most importantly, its EBITDA margins would increase by at least 200 basis points, making it the second-largest snack food company in the world. It’s easy to see why Mendes made the deal in the first place. It’s transformational.
Some of the growers interviewed by The Wall Street Journal might have a legitimate beef — or it could be sour grapes over a bad decision and signing away control over the price paid for their crops. It’s possible these growers resent the fact their businesses (10% of overall revenue assuming the Pringles deal went through) are no longer critical to Diamond’s success. That has to sting. Still, it’s amazing that these walnut growers, the company’s legacy, are willing to tear down all they’ve built over the timing of $50 million in walnut payments.
Regardless, Diamond Foods should be able to complete the Pringles deal despite any restatement that might occur. Procter & Gamble not only has a duty to shareholders to get a good price for the assets, which it did, but also to finally remove itself from the food business as stated in its business plan. I think only a glaringly obvious act of fraud on behalf of management will scuttle the deal. P&G wants this as much as Diamond does.
However, the future of Diamond Foods is bright with or without Pringles. As of Sept. 15, Diamond’s guidance for the first six months of fiscal 2012 is standalone (without Pringles) revenue of $540 million to $560 million and non-GAAP earnings per share of $1.65 to $1.75. Year-over-year it expects minimum revenue growth of 5.8% and non-GAAP net income by 4.4%. In a presentation it made in early September, all three of its snack brands (Emerald, Pop Secret and Kettle) are gaining market share — including outside the U.S. Diamond will find other snack food companies to buy, if not Pringles.
At this point, the professional money is staying on the sidelines. That doesn’t mean you should. On CNBC, trader Steve Grasso recommends investors should be buying upside calls, and I couldn’t agree more.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.