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2012 Was Nuts for Diamond Foods Investors

By Rich Duprey - Dec 28, 2012 at 12:15PM

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Scandal-plagued snack-foods company will find it hard to break out of its shell to restore value

"Liar, liar, pants on fire!" That childish catcall seems all too appropriate for walnut grower Diamond Foods (DMND.DL), which found itself mired in scandal this year. The CEO and CFO allowed improper payments to nut farmers to be classified as "momentum payments" that artificially boosted company earnings and ultimately led to their ouster.

Worse for Diamond, not only did it have to restate its financials going back two years and face a raft of class action shareholder lawsuits, it royally messed up its chance of becoming the second-biggest snack foods company behind PepsiCo's Frito Lay division. A deal with Procter & Gamble (PG 1.44%) to purchase its Pringles potato chip business for $2.35 billion would have put it on a footing comparable to General Mills and ConAgra, tripling its annual revenues to around $2.4 billion.

But as the resulting investigation into the payments broadened and delayed the acquisition, P&G looked elsewhere for a buyer and found one in Kellogg (K 2.02%).

The snack-foods business is huge and highly competitive. As the Fool's Nicole Seghetti notes, the global market opportunity is expected to reach $335 billion by 2015 as approximately half of all global snack-food sales occur in the U.S. Yet worldwide snack food consumption is also growing because the middle-class everywhere is developing Western-style snacking habits. We'll all grow fat together.

Mondelez International (MDLZ 2.64%) -- the old Kraft company that became an international snack-foods giant with the new, nearly unpronounceable name -- separated itself from the U.S. grocery business of Kraft Foods (KRFT.DL) precisely to better tap into that opportunity. It's the prize that Diamond had been eying when it made the move for Pringles.

Are you nuts?
When Diamond went public, nut farmers got both company stock and agreements that said it would take their entire nut crops. In boom times the farmers got paid less than market rates; in poor years they got paid more. But in 2010, nuts started generating a premium as demand soared, but Diamond's payments didn't, so it sent the farmers tens of million of dollars in what it called "momentum payments," money it was classifying as supposedly in advance of the coming year's crops, but in reality was for the prior year's shipments. The difference was not inconsequential.

By booking them the way they did, Diamond avoided booking the expenses against the prior year's revenues, which had the effect of boosting earnings. When it issued its restated earnings last month, reclassifying the payments wiped out 57%, or $39.5 million, of its income before taxes in 2011, and erased 42%, or $17 million of income, in 2010. For the first nine months of 2012, it generated earnings of just $0.53 a share, down from $1.54 a year ago.

Like chestnuts roasting on a fire
While the snack-foods maker has a new management team and its financials are now back in order, it's got to do some heavy lifting to gain the good graces of the analyst and investor community. If its last earnings call is any indication, however, Wall Street isn't ready yet to forgive and forget.

In one telling exchange on the call, an analyst said one of Diamond's priorities was restoring confidence: "You got to rebuild confidence in growers, you have got to rebuild confidence in the investment community and in perhaps the credit markets most importantly. You really didn't do a lot of that on this call, I have to say." It seemed many of the analysts were left unimpressed.

Diamond lost more than 57% of its stock's value in 2012, but more than 85% from the highs it was trading at just before the scandal broke. While Diamond did move swiftly in ferreting out the wrongdoing, and actually found and corrected the problem, it's doubtful it can regain its former highs. Much of the gains it enjoyed were based upon acquiring the Pringles brand, and with that catalyst removed from the equation, what's left to propel it higher? It seems to me Diamond's best hope lies in being a takeover target itself, at least after the legal liability has been resolved.

That's why I see the nut grower as mostly dead money for the balance of this year, but you can tell me in the comments section below whether you think I'm nuts for not wanting to get in on Diamond Foods at this price.

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Stocks Mentioned

Diamond Foods, Inc. Stock Quote
Diamond Foods, Inc.
Kellogg Company Stock Quote
Kellogg Company
$70.72 (2.02%) $1.40
The Procter & Gamble Company Stock Quote
The Procter & Gamble Company
$144.35 (1.44%) $2.05
Mondelez International, Inc. Stock Quote
Mondelez International, Inc.
$62.65 (2.64%) $1.61
Kraft Foods Group, Inc. Stock Quote
Kraft Foods Group, Inc.

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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