After reviewing Diamond Foods' (NASDAQ:DMND) mediocre first-quarter results and reduced guidance, not only did I shrug off the short-term hurdles, but I also found myself intrigued by Diamond's upside potential and reasonable valuation.

Diamond Foods is nuts about nuts. With a 36% market share, it's the largest processor of culinary nuts for cooking purposes. It also sells branded nuts (Emerald and Harmony), in-shell nuts (in the produce sections at grocery stores), and food-service nuts (for food processors and restaurants). Diamond's biggest customer is Wal-Mart (NYSE:WMT), which accounts for 19% of sales.

Although fiscal 2007 first-quarter results and guidance look disappointing on the surface, they aren't really too much cause for concern for long-term investors. Sales decreased to $170 million for the quarter versus $178 million last year, a drop attributable to a focus on higher-margin products. Nut shipments were delayed for about 10 days as well, and the walnut crop yield has been disappointing. As a result of these woes, the company missed earnings targets and lowered its sales growth target about 200 basis points to a range of 5% to 8%.

For the quarter, gross margin improved 210 basis points, but sales, general, and administrative spending climbed 160 basis points. Operating income more than doubled to almost $17 million from $7 million, but $3 million of that increase came from a one-time pension-curtailment gain, and another $3 million was due to timing differences in advertising spending. Excluding these differences, the figure improved by about 50% to $10 million.

Although slightly disappointing, the delayed nut shipments and reduced guidance don't change my view of how much free cash flow Diamond will produce in three to five years, so I'm not concerned about short-term results.

The bull case on Diamond hasn't changed: The branded Emerald snack-nut line, which is probably losing money because of slotting fees and advertising expenditures and is therefore artificially depressing the company's results, will one day be a major contributor to profitability. Management believes its snack sales will double to $80 million in 2007. Currently, competitor Planters has a mid-30% share in the snack-nut market, and Diamond's share in the tree-nut subcategory is 5%. Diamond's long-term goal is to be the No. 2 player, and given recent growth rates, the aggressive marketing and partnerships, and the fragmented competition (mostly from private labels), its goal seems attainable. At the very least, it should be able to eventually break even on this segment.

The company isn't very forthcoming with its financials -- the earnings press release doesn't include a balance sheet or a cash-flow statement. Even so, it's hard for me not to get interested when there is a clear catalyst for improved financial results (Emerald eventually breaking even) and a potential for explosive upside -- if the business meets all of its long-term goals. Diamond currently has a market cap of $275 million, a healthy balance sheet with net cash, and a run rate of $40 million (although there is some seasonality) in operating income if I use $10 million as normalized first-quarter operating income. At a potential valuation of less than eight times operating income, I'm very, very interested.

Related Foolishness:

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.