In May I wrote my first tumblr post on Diamond Foods’ Cap-ex (http://max0205.tumblr.com/post/23050278690/diamond-foods-cap-ex). In the post I suggested that Diamond had capitalized operating expenses and used three announced plant expansions at its Kettle subsidiary ($38 million in Beloit, WI; $8.4 million in Salem, Oregon and $10 million in Norwich, UK) as the vehicle for the accounting chicanery.

On November 14^th Diamond released their restated financials for FY2010/2011. They also released their unaudited results for the first three quarters of FY2012.

After the restatement was released, I reviewed Diamond’s restated financials and concluded that my cap-ex thesis was wrong. Diamond’s auditors did not make any material changes to Diamond’s cap-ex. And given the intensity of the forensic audit, I accepted that Diamond’s cash outflow for PP&E in FY2011 was accurately reported as $27.7 million.

Now having a full week to go through the released financials, I have changed course again and come to the conclusion that Diamond’s reported cap-ex still does not make sense.

One of the key parts of my overstated cap-ex thesis was Diamond’s use of an equipment lease to pay for the majority of its $8.4 million plant expansion in Salem, Oregon. Equipment leases require little cash outflow upfront and are paid over time.

If an equipment lease is classified as an operating lease, then both the liability and the asset remain off-balance sheet. If the equipment lease is classified as a capital lease, then both the asset and liability are brought on balance sheet.

Well it turns out not only did Diamond use equipment leases for its Salem plant expansion, but also for its Norwich plant expansion. And the accountants/audit committee have now decided to classify both as capital leases.

Below I copied Diamond’s new disclosures on its capital lease designation and the details of each lease.

“In addition to the restatements described above, the Company has made other corrections, some of which were previously identified, but were not corrected because management had determined they were not material, individually or in the aggregate, to our consolidated financial statements. These corrections related to stock-based compensation, foreign currency translation, timing of prepaid and expense recognition, capital lease designation, and deferred income tax.”

“On April 30, 2011, Diamond entered into a seven-year equipment lease for its Salem, Oregon plant (the “Kettle US Lease”) that has been treated as a capital lease for accounting purposes.”

“On January 30, 2012, Diamond entered into a five-year equipment lease for its Norfolk, UK plant (the “Kettle UK Lease”) that has been treated as a capital lease for accounting purposes.”

In the restated 10-K for FY2011, after the Salem lease was signed but before the Norwich lease was signed in January 2012, Diamond showed $6.3 million of capital leases. Diamond’s revised cash flow statement showed $5.376 million of non-cash investing capital leases for equipment in FY2011.

In Diamond’s original FY2011 10-K, filed 09/15/2011, Diamond disclosed no capital leases and $22 million of operating leases. With the reclassification of the Salem equipment lease as a capital lease, one would expect that the restated 10-k would show a corresponding $6 million decrease in operating leases to coincide with a $6 million increase in capital leases. Yet instead the restated FY2011 10-K still shows $22 million of operating leases and now an additional $6.3 million of capital leases. Total lease obligations (capital and operating) have magically increased by $6.3 million after the restatement, from $22 million to $28.3 million as of 07/30/2011.  

Small potatoes, right? I mean what’s $6 million of new liabilities and potential hidden expenses between friends.

The accountants/audit committee did not consider the $6 million of new liabilities material and hence the lack of a separate 8-k.  And since old management did not get the opportunity to present any false FY2012 10-Qs, the Norwich lease liability was never hidden.

Based on the newly classified capital leases, we now know that at least $12 million of the $18.4 million reportedly spent on the plant expansions in Salem, Oregon and Norwich, UK were through equipment leases. And tracking the YOY change of restricted cash or the proxy for the $21.4 million equipment loan for the Beloit, Wisconsin plant expansion, shows that Diamond spent $15 million on cash for equipment for Beloit out of the equipment loan (starting value of $21.4 million of restricted cash at April 30, 2011 down to $6.382 million as of April 30, 2012).

Diamond’s financials show $68.2 million of cash spent on PP&E over the last two years - $40.5 million in just the first nine months of FY2012 and $27.7 million FY2011. In order for the math to work, Diamond would have had to spend $53 million of cash on a combination of building costs at the three plants (based on property records it appears that at most could have been $13 million - $8 million in Beloit, $2 million Salem and $3 million Norwich), the automation of Emerald’s Breakfast on the go product line and maintenance cap-ex. 

When you consider the fact that Diamond’s prior management announced the Kettle Deal in February 2010, closed it one month later and within one year announced growth cap-ex worth 85% of the acquired $66 million of PP&E from Kettle ($56/$66), at the same time they were shifting expenses to inflate margins, the enormous growth cap-ex becomes even stranger. The math simply does not make sense. And once you start lying you generally do not stop.

Diamond’s new management on the conference call now says they have excess capacity at Kettle. Either prior management was completely delusional or there are more cockroaches.

I question whether the auditors will be able to sign off on FY2012 statements. I believe there is a strong possibility that Diamond’s former executives have pushed the cap-ex spending issues into FY2012.

RealPage announced the settlement of its litigation with Yardi on July 2^nd, 2012. RealPage’s 8-k on the settlement stated that:

“We expect second quarter earnings before income taxes to be reduced by $8-10 million (this amount will be added back for purposes of adjusted EBITDA) due to the litigation, plus we will make a net payment of $2 million for a perpetual license fee for certain interfaces and patents.”

RealPage’s 10-Q, for the quarter ended June 30^th, 2012, included a chart, on page 23, disclosing its calculation of Adjusted EBITDA. The chart added, as the 8-K on the settlement indicated, $8.5 million in litigation expenses back to net income to calculate Adjusted EBITDA. 

On page 18, however, of the same 10-Q, RealPage states the following with respect to its calculation of Adjusted EBITDA:

“Beginning in 2011, Adjusted EBITDA excludes litigation-related expenses pertaining to the Yardi litigation as discussed in Part II, Item 1, “Legal Proceedings.”

In fact, every RealPage 10-Q and 10-K, since Yardi filed its complaint on January 24^th, 2011, has included the same line, excluding the Yardi litigation expense from its calculation of Adjusted EBITDA.

This is in itself not significant. As it is likely that RealPage simply forgot to take out that line in its most recent 10-Q. The more interesting issue is why did RealPage decide to exclude its Yardi litigation expense from its previous Adjusted EBITDA calculations, when it was their only material litigation since their IPO.

The answer appears to be that up to this most recent quarter, RealPage did not have any material expenses related to its Yardi litigation. As RealPage’s insurance carriers were paying for all costs.

On May 30^th, 2012, however, Homeland Insurance Company of New York filed a lawsuit in Federal Court in the Northern District of Texas seeking declaratory relief against RealPage. Homeland asked the court to declare that they are not required to cover the Yardi litigation under its policy with RealPage, because of the wrongdoing by RealPage that led to the litigation.

Homeland Insurance’s policy with RealPage is an “Excess Technology, Media and Professional Liability Policy” covering RealPage up to $5 million in excess of $15 million. In effect, in order for RealPage to ask Homeland to pay out, it first needs to have $15 million of expenses related to the Yardi litigation that other insurance carriers have picked up.

Lloyds of London is the primary carrier for RealPage picking up the first $5 million, Axis Surplus Insurance picks up the second $5 million and Continental Causality picks up the next $5 million. And then Homeland is the last layer of insurance and is required to pick up $5 million in excess of $15 million.

As of May 30^th 2012, RealPage exhausted the limits of its Lloyds and Axis policies and was close to exhausting its Continental Causality policy. RealPage then made repeated demands that Homeland contribute to the settlement of the Yardi litigation.

RealPage, clearly, was expecting its Yardi litigation to cost in excess of $15 million. Yet because their insurance carriers had already picked up the first $15 million, they had not yet had any material expenses related to the Yardi litigation.

After Homeland refused to pay on its $5 million in excess of $15 million policy, RealPage appears to have decided to start including its Yardi litigation costs in its calculation of Adjusted EBITDA. 

When you consider the $8.5 million litigation expensed in the second quarter of 2012, in relation to RealPage’s other disclosed litigation insurance coverage, one can surmise that its total Yardi litigation expense, up to June 30^th, 2012, was approximately $23.5 million - $15 million paid out by its first three layers of insurance, plus $8.5 million of litigation expense in the second quarter of 2012, with Homeland refusing to pay out its $5 million in excess of $15 million.

The good news for RealPage is if the court does accept Homeland’s argument, RealPage will not have any obligations towards Homeland. RealPage will just not be able to collect on their $5 million excess insurance policy.

The bad news for RealPage, is that after Homeland decided to challenge its insurance policies, their other carriers decided to ask for the amount they paid out to be paid back.

On August 14^th, 2012, RealPage brought its own declaratory suit against Ace and Lloyds. According to the complaint, RealPage exhausted the first $5 million policy in November 2011 and then exhausted their second $5 million policy on March 1^st, 2012.

After the settlement was announced on July 2^nd, 2012, Lloyds and Axis, respectively, declared their policy void/rescinded and demanded RealPage return its entire insurance payment.

The crux of Lloyd and Axis’s argument for the return of their payment is that RealPage was aware of the pending litigation, based on October 4, 2010 letter from Yardi to RealPage, and that letter was not disclosed in their insurance application. If RealPage loses its suit, it could be forced to pay back the $10 million it received from both Lloyds and Axis.

The two separate suits between RealPage and its insurance carriers are both active and there has been a heavy amount of activity in both cases. Unfortunately all the material documents in the Homeland case are under seal, based on a RealPage request - presumably because it contains details about its confidential settlement with Yardi.

RealPage has consistently downplayed the Yardi litigation while it was ongoing. And then when the case settled, RealPage put out a press release that did not include any mention of any settlement payments to Yardi. And in their 8-K on the settlement, RealPage mentioned the $8.5 litigation expense without explaining whether it was for legal fees or settlement costs.[1]

RealPage should provide better disclosure with respect to its Yardi litigation, including the true cost of the litigation and settlement. RealPage has never even generated free cash flow in a given year , when including stock based compensation, that would cover the cost of its litigation/settlement with Yardi.

Regardless, now that two RealPage’s insurance carriers are requesting the return on insurance payments, RealPage shareholders may over time feel the full extent of the cost of the litigation.

And when you view the litigation with the Yardi in relation to the $900k acquisition of Evergreen Consulting that led to the lawsuit, a investor might rightfully ask the following:

Why did the acquisition of Evergreen Consulting from Georgianna Oliver in 2009 for $900k – whose business was shut down less then two years after RealPage bought it and who sold her other company AptBudget that was never launched for $400k to RealPage in an undisclosed transaction that help financed her congressional campaign in 2008 - lead to such a large and costly lawsuit?

Footnote:

[1] As mentioned previously, the approximate all in costs of the litigation, including potential settlement amounts, appears to be $23.5 million.

If you assume the actual litigation cost was $23.5 million and there no was settlement payments to Yardi, then a law firm averaging a billing rate of $500/hr between associates/partners, would have to bill 47,000 hours to charge $23.5 million for its legal work or the equivalent of 23 attorneys at the firm each billing 2000 hrs on the matter.

And if you assume of the approximately $23.5 million in litigation costs, $8.5 million of litigation expenses in the disclosed in the 8-K was the extent of the settled amount, then a law firm averaging $500/hr between associates/partners, would have to bill 30,000 hrs to charge $15 million for the litigation or the equivalent of 15 attorneys at the firm each billing 2000 hrs on the matter.

And even stranger is Axis’s insurance $5 million payout, which covered RealPage’s Yardi litigation expense after Lloyd’s primary coverage was fully paid out in November 2011. Axis sent RealPage $5 million in the four months between November, 2011 and March 1^st, 2012. Since that amount was paid out by Axis before the settlement in July 2012, the payout was likely just related to legal fees. 

Therefore, for a grand total four months of legal work, a law firm averaging a billing rate of $500/hr between associates/partners, would have to bill 10,000 hours to charge $5 million for its legal work or the equivalent of 5 attorneys at the firm each billing 2000 hrs on the matter in four months. Or since four months is the equivalent of 2921.94 hours, three lawyers billing for their work 24 hours day, 7 days a week for four months would bill 8,765.82 hours and one lawyer would have to bill 1,235 hours during that same four months for the RealPage to accrue $5 million in legal costs.

That is expensive litigation for a case that never went to trial and only involved claims, counterclaims, answers and discovery. Must have been some intense and costly discovery.

The math simply does not make sense.

A Heard on the Street article today in the Wall Street Journal (http://online.wsj.com/article/SB10000872396390443890304578006694063312014.html?mod=ITP_moneyandinvesting_5) addressed the issue that is often ignored by investors – the true share count for publicly traded companies.

Given the article, I thought I would provide my calculation for RealPage’s shares outstanding. 

Google Finance, Yahoo Finance and Bloomberg all report that RealPage has 73.66 million shares outstanding.  RealPage in its last 10-Q also reported 73.66 million shares outstanding. As reported in a recent RealPage prospectus, the 73.66 million excludes the following:

•

700,000 shares of our common stock potentially issuable in connection with earn-outs for acquisitions completed before the date of this prospectus supplement, of which 100,000 were issued between June 30, 2012 and the date of this prospectus supplement;

•

7,210,391 shares of common stock issuable upon the exercise of options outstanding as of June 30, 2012, with a weighted average exercise price of $11.31 per share;

•

361,516 shares of our common stock issued pursuant to restricted stock awards after June 30, 2012 under our 2010 Equity Incentive Plan; and

 Based on this disclosure, I have included 7.66 million additional shares in my valuation of RealPage (7.2 million options in the money, .36 million restricted stock awards, .1 million issued from earn out) to bring the total shares outstanding to approximately 81 million shares.

Based on the current share price, RealPage’s market cap is 10% higher at 1.92 Billion then the 1.744 Billion reported on Bloomberg, Yahoo and Google. This is not a small difference, particularly for a company with such a stretched valuation. 

On June 10, 2008 Georgianna Oliver officially became the Democratic candidate for the U.S. House of Representatives from the First District of Oklahoma. In order to finance her campaign, Ms. Oliver loaned $441,548.62 to her authorized committee, Oliver for Congress. 

The first loan was taken out on July 11th, 2008 for $51,000. Ms. Oliver went on to make eighteen more personal loans to her authorized committee up until November 24th, 2008, twenty days after the election on November 4th, 2008.  The largest loan was taken on September 19, 2008 for $260,000.  

In September 2008, right before Ms. Oliver loaned her campaign $260,000, AptBudget, a software firm, was sold to RealPage Inc. (“RP”) for $400,000. 

Subsequent to the sale of AptBudget, Ms. Oliver made a total of 15 personal loans to her campaign for a total of $365,608.19, including the $260,000 loan made on September 19th, 2008. [^1] Prior to sale of AptBudget, Ms. Oliver made 4 loans to her campaign totaling $80,540.42.

AptBudget was officially launched on March 20, 2008 by Evergreen Solutions (http://www.multihousingnews.com/news/evergreen-launches-multifamily-budget-tool-that-eliminates-spreadsheets/1003742178.html). Ms. Oliver was the President, CEO, sole board member and sole shareholder of Evergreen.  

In July 2008, two months before being sold to RP, AptBudget software was still being beta-tested, had not been priced and produced no revenue for Evergreen (http://www.dolanmedia.com/view.cfm?recID=396946). In October 2008, Ms. Oliver told the Tulsa World with respect to AptBudget: “The software we were developing was never finished.” AptBudget never was officially launched or finished by RP (http://aptbudget.com/). 

Ms. Oliver, at the time she filed her House Financial Statement in August 2008, disclosed that she was the President of AptBudget, LLC. Ms. Oliver did not list AptBudget as an asset in her House Financial Statement, because, as she later claimed, AptBudget had no value in August 2008. She then subsequently stated that AptBudget value was included in the value of Evergreen as an asset held as as an accounts receivable. 

According to the Federal Election Commission’s First General Counsel’s Report the money flow between AptBudget, Evergreen, RP and Ms. Oliver was the following:

• AptBudget owed debt to EverGreen (i.e. EverGreen held the debt as an account receivable).

• Proceeds from the sale of AptBudget to RP went toward the amount owed to EverGreen, although the amount of the receivable held by EverGreen exceeded the sale price.

• Following the sale of AptBudget and the payment of its debt, EverGreen paid a cash distribution to [Ms. Oliver] as sole shareholder pursuant to Evergreen’s Bylaws. 

On July 30th, 2009, ten months after the acquisition by RP, AptBudget, LLC filed its required annual report with the Secretary of State of Oklahoma.  The annual report noted that the LLC was not active. The document was signed by Ms. Oliver as Manager.  On September 24th, 2010, the Secretary of State of Oklahoma certified that AptBudget, LLC was inactive for failure to file its annual report and was not in good standing. 

There is no record of any press release being issued by either Evergreen, RP or Ms. Oliver announcing that AptBudget had been acquired by RP. In RP’s S-1 filings, prior to its IPO in August 2010, they included a section on their acquisitions in 2008. They mentioned two acquisitions, one made in January 2008 ($1.2 million) and the other in October 2008 ($21.6 million). There was no disclosure in the S-1 of the AptBudget acquisition in September 2008.

The only public record of the AptBudget acquisition comes from the reporting of Jim Myers at the Tulsa World. His articles raised questions on how Ms. Oliver was self-financing her campaign. Those articles led to a complaint being filed with the Federal Election Commission. [^2]

In September 2009, one year after RP bought Aptbudget, Evergreen was sold to RP for $900,000 (cash payment of $0.7 million and the fair value of contingent consideration of $0.2 million). Ms. Oliver was the President, CEO, sole board member and sole shareholder of Evergreen. 

RP in their S-1 filing prior to their IPO in 2010 disclosed the following about their acquisition of Evergreen:

In September 2009, we purchased substantially all of the assets of Evergreen Solutions, Inc. (“Evergreen”). The acquisition of Evergreen further advanced our ability to offer open access to our products for clients and certified partners, and improves our ability to offer integration of our products and services with third-party solutions. The aggregate purchase price at closing was $0.9 million, which included a cash payment of $0.7 million and the fair value of contingent consideration of $0.2 million, which was paid in March 2010 and is based on the collection of pre-acquisition accounts receivable balances from customers. The $0.2 million is recorded within the current portion of acquisition related liabilities on the balance sheet at December 31, 2009. The customer relationships have useful lives of four years and are amortized in proportion to the estimated cash flows derived from the relationship. We have determined that the tradename has an indefinite life, as we anticipate keeping the tradename for the foreseeable future given its recognition in the marketplace. All direct acquisition costs were immaterial and expensed as incurred. We included the operating results of this acquisition in our consolidated results of operations from the effective date of the acquisition.

Evergreen, prior to being acquired by RP, was best known for providing technology and software support services almost exclusively for users of Yardi’s (RP’s chief competitor) software.

On January 24th, 2011, Yardi sued RP for wrongfully infiltrating Yardi’s password protected internal website, altering Yardi’s confidential information and illegally downloading Yardi’s software.  

Yardi alleged in its complaint that RP acquired Evergeen so that it could exploit Yardi’s confidential information that Evergreen had by virtue of its prior status as an authorized member of the Yardi Independent Consultants Network. 

According to RP’s management, Evergreen’s consulting business was officially discontinued as of December 31, 2011, two years after the acquisition. 

On July 2nd, 2012, Yardi and RP announced the settlement of their litigation. 

Yardi Systems, Inc. has announced a comprehensive settlement to the litigation that has been pending between Yardi and RealPage, Inc. since January 2011. As part of the settlement, RealPage will immediately stop offering to host Yardi software for new customers. RealPage will also immediately discontinue offering implementation services and all application support and training services for Yardi software. RealPage may continue to host Yardi software in the RealPage Cloud for existing RealPage Cloud customers only, for up to five years. In addition, Yardi and RealPage have granted to one another perpetual licenses to their standard interfaces, providing interoperability and choice to common clients.

These are all facts that are not in dispute. And what the facts suggest is troubling for  the credibility of RP’s management. 

The circumstantial evidence makes it appear that RP engaged in a sham transaction with Ms. Oliver to buy a worthless entity – AptBudget, LLC  - to finance Ms. Oliver’s run for Congress in 2008. And then RP a year later bought Ms. Oliver’s other company, Evergreen, for illegitimate business purposes in order to gain access to its chief competitors propriety software.

Or more generally the facts imply the following: we buy your worthless entity to finance your Congressional Campaign; and you sell us your consulting business so that we can gain access to your largest client’s (our chief competitor) propriety info.  

Financing a campaign through artificial corporate transactions is not only unethical but a crime. See  http://www.justice.gov/opa/pr/2004/January/04_crm_060.htm 

I believe it would be helpful to investors if RP’s management would answer the following questions with respect to their relationship with Ms. Oliver, AptBudget and Evergreen:

1. Why did RP buy AptBudget in September 2008 when AptBudget had no revenue, was still being beta tested and Ms. Oliver told the Tulsa World that AptBudget had no value in August 2008?

2. Why didn’t RP put out a press release announcing the acquisition of AptBudget?

3. Why didn’t RP disclose the AptBudget acquisition in its S-1 filing under the 2008 acquisitions section?

4. If AptBudget was worth acquiring why was it never launched? 

5. Did RP know the money from the sale AptBudget would be funneled to Ms. Oliver through Evergreen as loan to herself to finance her Congressional Campaign? 

6. Did RP view the two transactions with Ms. Oliver as one transaction? 

7. Did RP make any promises to Ms. Oliver when they bought AptBudget? 

8. Did RP gain access to Yardi’s propriety information prior to the acquisition of Evergreen? 

9. Why did RP decide to shut down Evergreen two years after acquiring it?

10. Why did Ms. Oliver leave her employment with RP as a consultant this year?

11. Does RP still have a relationship with Ms. Oliver?

12. Is RP interested in buying Ms. Oliver’s new company Empire Technologies?

Footnotes:

[^1] $365,608.19 is equal to 91% of the sale price of AptBudget and 82% of the total amount of Ms. Oliver personally loaned her campaign.

[^2] The First General Counsel’s report recommended that the Commission “find reason to believe that Evergreen Solutions made, and Oliver and Oliver for Congress knowingly accepted, prohibited corporate contributions in violation of 2USC 441b(a).” The Commission, however, decided to drop the complaint in a 4-2 vote citing prosecutorial discretion. The Commission’s statement of reasons cited the fact that Ms. Oliver attested under oath that the distribution of money was in accordance with Evergreen’s bylaws, even though a copy of the Bylaws was not provided to the Commission, nor any proof of the formal corporate relationship between AptBudget and Evergreen. If the Commission followed through on its General Counsel’s recommendation, it is likely that Ms. Oliver would have been deposed and would have been required to provide proof of the legitimacy of the transaction. The Commission’s decision was signed September 28th, 2009, five days after RP acquired Evergreen from Ms. Oliver. 

Disclosure: The investment partnership I control is short the shares of RealPage

Sources:

http://eqs.sdrdc.com/eqs/searcheqs?SUBMIT=documents

http://eqs.sdrdc.com/eqsdocsMUR/29044252174.pdf

http://eqs.sdrdc.com/eqsdocsMUR/29044252202.pdf

http://eqs.sdrdc.com/eqsdocsMUR/29044252205.pdf

http://eqs.sdrdc.com/eqsdocsMUR/29044252208.pdf

http://eqs.sdrdc.com/eqsdocsMUR/10044261561.pdf

http://eqs.sdrdc.com/eqsdocsMUR/29044252219.pdf

http://www.tulsaworld.com/news/article.aspx?subjectid=11&articleid=20081016_16_A9_TeDmca101931&allcom=1

http://www.tulsaworld.com/news/article.aspx?subjectid=11&articleid=20081017_16_A13_hOlive866841&allcom=1

http://www.tulsaworld.com/site/printerfriendlystory.aspx?articleid=20081023_16_A9_hQuest657105&PrintComments=1

http://www.tulsaworld.com/news/article.aspx?subjectid=11&articleid=20091020_16_A4_WSIGOm151654

http://www.dolanmedia.com/view.cfm?recID=396946

http://tsi.brooklaw.edu/sites/tsi.brooklaw.edu/files/filings/yardi-systems-inc-v-realpage-inc-et-al/20110124initial-complaint.pdf

http://www.yardi.com/US/legal.aspx

http://www.linkedin.com/pub/georgianna-w-oliver/4/248/520

http://www.campaignmoney.com/political/campaigns/georgianna-w-oliver.asp?cycle=08

http://www.multihousingnews.com/news/evergreen-launches-multifamily-budget-tool-that-eliminates-spreadsheets/1003742178.html

https://www.sos.ok.gov/corp/corpInquiryFind.aspx

http://aptbudget.com/

https://www.kssos.org/filed_doc_viewer/view_entity.aspx?id=06022000288550712&submit=View+History+and+Documents

https://corp.dcra.dc.gov/

http://oliverforuscongress.blogspot.com/2008/09/candidate-and-foodie.html

On July 2^nd RealPage (“RP”) and Yardi announced the settlement of their litigation.

First things first, my tail risk thesis has been rendered null and void by the settlement. I argued, in my last post, that the litigation could result in large monetary damages, which RealPage had not reserved for and could not afford to pay without taking a large hit to its future earnings. This outcome did not happen and therefore part of my valuation thesis was wrong. 

According to RP’s 8-K, they will only take, at most, a $12 million hit to their second quarter earnings.  This will likely mean that RP will report a loss in the second quarter on a GAAP basis. The $12 million will be added back to adjusted EBITDA and since the market generally seems to value RP on an adjusted EBITDA, the effect of the litigation costs is negligible to RP.

RealPage and Yardi each put out their own respective statements on the settlement - Realpage: http://investor.realpage.com/releasedetail.cfm?ReleaseID=688350 and Yardi: http://www.yardi.com/US/legal.aspx.

Without a large monetary damages, analyzing the settlement and its effect on RealPage becomes more nuanced.

The key language of the settlement can be found in the last two sentences of RP’s press release (this language is the focus of Yardi’s much shorter statement):  

RealPage will continue providing Voyager hosting to current clients for five more years.  RealPage also has agreed to stop offering hosting services for Yardi software to new customers and to stop providing support or implementation services for Yardi software.

And here is Yardi’s entire statement:

Yardi Systems, Inc. has announced a comprehensive settlement to the litigation that has been pending between Yardi and RealPage, Inc. since January 2011. As part of the settlement, RealPage will immediately stop offering to host Yardi software for new customers. RealPage will also immediately discontinue offering implementation services and all application support and training services for Yardi software. RealPage may continue to host Yardi software in the RealPage Cloud for existing RealPage Cloud customers only, for up to five years. In addition, Yardi and RealPage have granted to one another perpetual licenses to their standard interfaces, providing interoperability and choice to common clients.

So in essence, the settlement prohibits RP from hosting Yardi’s software on its servers for new customers. And for current customers it can continue to host Yardi’s software for five years. RP also immediately has to stop servicing and providing support for Yardi’s software for current and future customers.  

No big deal right? I spoke to the investor relations department at RP and they said as much. The cloud is only 3% of their current revenue, so the settlement has no material impact on them.

The problem with this logic is that it assumes the real estate management software industry is static and that the RP Cloud infrastructure, along with the ability sell additional software as a service (SaaS) into that infrastructure is not important to the future of RP.

I have recently re-read all RP’s earnings calls since the IPO in 2010. And what is noticeable is RP’s management tone pre-Yardi litigation and post litigation with respect to the cloud infrastructure.

In their first call in November 2010, RP’s management was eager to talk to sell-side analysts about the cloud and its importance in cross-selling software.

For example, here is a comment from RP’S CEO, Steve Winn, on RP’s first quarterly conference call after the IPO in November 2010:

it’s a catalyst for facilitating the sale of all of our SaaS products because we’re — data is hosted and our data center, and the integration tends to be as good as it could get when you do that. So we believe that infrastructure as a service is very complementary to our SaaS offerings, and candidly, that’s the primary reason why we’re in that business.

But as the litigation was filed and progressed with Yardi, RP’s tone about the cloud changed fairly dramatically. They began to deemphasize it. 

RP claimed it was because Yardi’s litigation unfairly interfered with their business. Yardi would say in response that RP’s cloud customer wins in November 2010 was the result of RP’s interfering with their business by stealing propriety information. 

Either way, it is clear based on the settlement, that RP’s cloud infrastructure might become permanently impaired.

I imagine RP’s management will continue to say this is no big deal. But the question for investors is not what RP’s management tries to tell sell-side analysts, but what the reality is and where the industry is actually going. 

To help understand the potential effect of the settlement on RP, I included below every reference to the Cloud and SaaS from RP’s quarterly conference calls since the IPO.

As you read through the transcripts, see if you notice the shift.

From November 3, 2010 Conference Call:

STEVE WINN:

Our top five multi-family deals for the quarter included broad-based adoption of product families with particular emphasis on the RealPage cloud, our infrastructure-as-a-service offering, and YieldStar, our asset optimization system. We recently closed four cloud service deals, including Riverstone Residential, Pinnacle, and Greystar, which are the three largest apartment managers in the United States per the latest National Multi Housing Council report.

Large customers have responded to the RealPage cloud because it enables owners and managers to outsource portions of their IT operations and divert internal IT resources to more strategic business process improvement initiatives within their companies.

ROB BREZA, ANALYST, RBC CAPITAL MARKETS: Nice quarter. Steve, I was wondering if you could talk a little bit more about the cloud wins that you had. You talked about four of the big deals. Is it more of a focus from the sales effort? Really just wanted to get more clarification in how you see that traction going forward may be over the next 12 months.

STEVE WINN: Clearly, the concept of infrastructure-as-a-service is now becoming understood in the industry as it has in many other industries, and we’re typically excited that the three largest management companies in the US saw the value and literally all moved to the cloud in the same quarter.

This line of business is still only 3% of revenue, so it’s not big, but we do think there’s a significant value proposition to the industry to adopt cloud infrastructure versus trying to finance and manage these complex systems themselves.

TOM ERNST, ANALYST, DEUTSCHE BANK: I have two for you today. Following up on the questions on the infrastructure-as-a-service, my understanding is a couple of your early deals were at some of the larger customers in your base. These four newer deals you have; are they also with larger customers? And then, what is this doing in terms of your ability to sell the broader suite into the customer when you host the infrastructure as a service for them?

STEVE WINN: Well, to answer the last question, I think it makes — it’s a catalyst for facilitating the sale of all of our SaaS products because we’re — data is hosted and our data center, and the integration tends to be as good as it could get when you do that. So we believe that infrastructure as a service is very complementary to our SaaS offerings, and candidly, that’s the primary reason why we’re in that business.
These bigger wins we’ve been working on for a long time and they just finally came together in this quarter. It could have happened sooner because we’ve been working on them for a year. Maybe I didn’t understand the question —

TIM BARKER: Yes, Tom, the four we talked about were at the four large ones.

TOM ERNST: Right, that’s what I thought, okay.

And I recognize you’ve only had a couple of these deals prior to these new deals in infrastructure-as-a-service, but what has been the track record of continuing to upsell into that base once you’ve got them hosted in your data center?

STEVE WINN: It’s been — it’s a little early to tell for sure, because we have a substantial amount of business already from Riverstone, Pinnacle, and Greystar. But, specifically, in the case of Riverstone, they have expanded the use of other SaaS offerings that we have co-terminus with the move to the cloud, so there is evidence here that there is a linkage.

From May 5, 2011 Conference Call:

STEVE WINN:

Finally, revenue from the RealPage cloud offering grew significantly over last year. Notwithstanding year over year growth in Q1, we believe the success of our cloud offering and related consulting services has been damaged by uncertainties surrounding the lawsuit that is now pending between RealPage and Yardi Systems.

As you know we responded to Yardi’s complaint with an answer, affirmative defenses and counterclaim. That counterclaim explains why we are seeking judicial relief from Yardi’s interference with our business relationships and clients.

Our cloud revenue and consulting services are immaterial to our overall business. But the cloud does deliver a substantial value proposition to our customers which we highlighted in our April 25 press release.

From August 4, 2011 Conference Call:

STEVE WINN: As a SaaS provider, one of the benefits that RealPage brings to the table is very low implementation and training costs. Our implementation and training revenue is only 5% of total revenue. If you contrast that with a typical software or ASP, they’ll have 30%, 40%, 50% of their revenue generated from professional services. So we are highly motivated and highly successful at reducing the overall cost of implementation and training, as evidenced by the fact that we’re generating such a small amount of revenue from that activity.

Now the cost to implement is very dependent upon the product centers. Clearly, when you replace your back office accounting and property management system, that is going to take more consulting than, say, screening or renters insurance, or even the contact center is very easily brought up.

So there’s no simple answer to the question. It’s a function of what product we’re talking about. But SaaS is the advantage here because we can bring the systems up very cost-effectively.

STEVE WINN: The competitive landscape is always tough. There’s some really good competitors out there that we compete against in every product family. Yardi, we primarily see in the property management area, although they have expanded their presence into screening and utility billing and a few other areas. But they’re not — they haven’t reached a critical mass in those other areas where there are serious competitors. But those other areas do have very serious competitors.

I guess the cloud, which represents a very small percentage of our revenue today, I would say is being impacted from a competitive standpoint, primarily due to Yardi’s interference. They do not want RealPage to host or support their application, and they are attempting every way possible, including illegal ways, in our opinion, to block the sale of the cloud. And I think this is most damaging, candidly, to the industry because the industry desperately needs the performance and cost advantages that the cloud brings to them. But that’s really the only area where I’d say things have really changed, is in the cloud. And again, stress this is a very minor part of our overall business today.

From November 1, 2011 Conference Call:

RICHARD BALDRY: Yes. And do you leave them as really product specialists in the line they’re brought in with, or do they (multiple speakers)? Right.

STEVE WINN: There’s not a hard and fast rule here, but I would say the majority do stay as specialty reps for the product family, not necessarily the product. So, if you look at each product family like LeasingDesk and LeaseStar, and we would have a specialty rep that is qualified to sell all of the individual product centers that make up a particular product center or family. The largest number of reps clearly are the general territory reps that support all products.

With respect to competition, I — we generally don’t like them, but — because they’re all tough in every market that we compete in, there’s some very good high quality companies that we compete against. So, I haven’t seen a change in the competitive landscape really. They’re as fierce and they’re hard to compete against today as they were three months ago. I think we have some significant differentiation between ourselves and all of the competition that we compete against. Our primary differentiator, of course, is our SaaS platform, and our total comprehensive integrated solution, which none of the competition has really been able to [piece] together and offer.

So that will be the way we differentiate against the overall market. But having said that, it is paramount that we being best of breed within each product family, we can’t rely on the overall integration to win a deal, if we’re not at least at parity and ideally better in terms of the functionality of each product family that we offer.

I don’t know that the Yardi lawsuit is going to have any impact on competition other than the RealPage Cloud, which we have discussed in previous earnings calls. Yardi has been successful in dramatically slowing down the growth of that particular opportunity for us. So, until this matter is resolved, I’m not anticipating that the RealPage Cloud is going to be a big contributor of growth to RealPage.

From May 3^rd, 2012 Conference Call:

JEFF HOUSTON: Okay. Then separately, turning to competition, are you seeing more of Yardi now that they have introduced a SaaS product? And have the win rates changed at all when you do face off with Yardi?

STEVE WINN: Well, Yardi recently announced a SaaS platform, which we’re delighted they finally adopted the model that we’ve said is the correct way to do business. It’s too early, I think, at this point to know what impact that’s going to have on the market. And remember that Yardi and RealPage compete in this area where they released their Voyager SaaS product primarily in the ERP product family, which is a reasonably small percentage of our overall revenue now.

RealPage (NASDAQ: RP), a real estate software company, is a work of valuation fiction that can only be created by Wall Street.

RP sells software to property managers. In the trailing twelve months, RP generated, on a GAAP basis: $1.14 million of net income, EBIT of $4.6 million and EBITDA of $33.67 million, which produced a whopping .87% ROA, .44% ROIC, .55% ROE and a 12.9% EBITDA margin.

Of course management wants us to ignore GAAP metrics. They, along with their sell-side underwriters, want investors to pretend that revenue from acquisitions has no cost (ignore the amortization of acquired intangibles) and that stock-based compensation is not a real expense (Hello 1990s!).

Using Non-GAAP figures for FY2011, RP produced an adjusted EBITDA, excluding stock based compensation, of $56 million and a free cash flow, excluding stock based compensation and acquisitions costs, of $33 million.

If you include stock based compensation, then free cash flow shrinks to $11 million ($22.6 million of stock based compensation in FY2011). RP had negative free cash flow of $80 million, if you include the $90 million spent on acquisitions.

Putting this all together, the market has decided to value RP, as I am writing this, at a market capitalization of slightly over $1.5 billion. This equates to 26X adjusted EBITDA (which excludes stock based compensation) or 44X EBITDA that includes stock based compensation. And 44X FCF that excludes stock based compensation and 136X FCF that includes stock based compensation.

Of course when you buy a stock you are buying the future not the past. The market clearly expects rapid growth and margin expansion for RP.  

The sell-side claim is that the domestic real estate management software is a potential $9 billion market and that RP is currently only 3% of the total market. The sell-side argues that RP currently only generates $38.45 of annual revenue per unit and will reach eventually $225 of annual revenue per unit.  And multiplying $225 per unit by 40 million total domestic apartment units gives RP enormous runway into the future.  That is the hope.

The reality, of course, is quite different. RP’s growth is decelerating and becoming more expensive in real terms.  Sales & marketing expenses are growing, as the productivity of their sales force is declining each quarter sequentially.

This reflects the real problem with the sell-sides’ bull case. The addressable market is much smaller. The vast majority of large property managers already use either RP or its competitors’ software. In order to reach new customers, they need to convince smaller property managers to adopt high priced software. This will be increasingly difficult, as most small property managers can use excel or simpler, cheaper software like Appfolio. 

In addition, RP needs to continuously sell new products to its current customers to generate higher annual revenue per unit. But beyond the core software, most property owners do no not require additional features. As a result, annual revenue per unit growth each quarter continues to grow slower then the Street expects. And many of the new products RP offers are from acquisitions and not developed organically; even though management wants investors to ignore the cost of acquisitions.

So this adds up to what looks like a great short opportunity. The market structure of the stock, however, is negative for shorts. Management still controls a little over 50% of the float down from 70% after the IPO in August 2010. So squeezes will be frequent and arbitrary.

But there is one more thing. There is a large liability lurking. RP is being sued by its main competitor Yardi for misappropriating propriety information and trade secrets.

Here is RP’s disclosure on the litigation in its last 10-Q:

On January 24, 2011, Yardi Systems, Inc. (“Yardi”) filed a lawsuit in the U.S. District Court for the Central District of California against RealPage, Inc. and DC Consulting, Inc. and filed a First Amended Complaint on August 12, 2011. On March 28, 2011, we filed an answer and counterclaims, on May 18, 2011, we filed amended counterclaims, on September 2, 2011, we filed Second Amended Counterclaims and on September 12, 2011, we filed an answer to Yardi’s First Amended Complaint. Yardi has also filed a pending motion to dismiss several of our counterclaims which we have opposed. On February 13, 2012, the Court denied Yardi’s motion with respect to all claims except for a portion of one of our claims for intentional interference with contract, as to which dismissal was granted. Accordingly, RealPage will move forward with its claims against Yardi. We currently expect trial in this case to be scheduled for January 2013. We intend to defend this case and pursue our counterclaims vigorously. It is not possible to predict the outcome of this case, and as such, we have not recorded a contingent liability as we do not believe an unfavorable outcome is probable or reasonably estimatable as of March 31, 2012.

Yardi has put together a helpful website with all the filings to date http://www.yardi.com/US/legal.aspx. I would recommend anybody interested in shorting RP, read every filing.

Here is the gist of the suit: RP acquired a consulting firm called Evergreen in 2009. Evergreen, as a consultant for Yardi, had access to confidential information.  After acquiring Evergreen, RP employees broke into Yardi’s system to steal propriety information and trade secrets. By doing so, RP was able to copy many of Yardi’s software features that helped develop their software and convince Yardi’s clients to switch over.

Yardi’s claims are extraordinarily serious, even if RP wants to downplay them. Yardi in its complaint says they have found 200 instances of IP addresses that belong to RP breaking into Yardi’s system by using the username and password of Yardi’s customers, employees or consultants. Yardi lists out several of these instances, in great detail, in its complaint.

So what was RP’s response: first instead of addressing Yardi’s allegations, they spent the first six pages of their answer to Yardi’s complaint talking about how great their product is and then the next 21 pages making six counterclaims of their own for misappropriation of trade secrets, antitrust violations, intentional interference of contract and unfair competition.

And then finally on page 29 of their response, they answered Yardi’s charges. Their defense appears to be that the access did occur, but was harmless. Or as the president of RP, Dirk Wakeham, wrote to RP clients in addressing Yardi’s claim:

As you can see in our pleading, each of the instances of downloading described by Yardi in its Complaint either (i) was a lawful action conducted on behalf of a RealPage client, (ii) was accidental and innocuous, or (iii) concerned material that was not, in fact, a trade secret, and for these and other reasons, Yardi suffered no harm.

RP’s six counterclaims in response to Yardi’s lawsuit, which they never mentioned to their shareholders or anyone prior to their filing in response to Yardi’s lawsuit, appear weak. One of the counterclaims, the intentional interference of contract was dismissed with prejudice.

It took two amended complaints for RP to get their antitrust claims passed Yardi’s motion to dismiss. In a motion to dismiss, the judge assumes all the allegations in the complaint are true,  and then decides whether there is still a credible legal claim. This is a pretty low bar to get over.

RP has high priced litigators at O’Melveny & Meyers.  High priced litigators at a major law firms usually do not take three tries to find a credible claim to get passed a motion to dismiss, particularly when the facts and the law are in their favor. I think this speaks to the credibility and strength of RP’s antitrust claims.

The most serious counterclaim by RP, is that one of it former employee’s was a mole for Yardi and stole its propriety information.

As for this claim, which RealPage will have the opportunity to prove in court, I think Yardi’s response, in its answer to RealPage’s counterclaim, goes right to the credibility of RP’s management:

“RealPage does not explain, nor could it, why, if this supposed theft had the effect on RealPage’s business that it claims, RealPage never once uttered one word about it — not to Yardi, not to RealPage investors … not to anyone. Instead, RealPage allegedly hid this serious accusation from its investors and the public for two years, only to surface it in response to Yardi’s allegations, now admitted by RealPage, that RealPage broke into Yardi’s website and stole its intellectual property. One of two things is true. Either, for two years, RealPage concealed the fact that its trade secrets had been compromised by its leading competitor or, as Yardi knows and will prove in court, RealPage has fabricated the whole story to distract from the serious allegations against it …” 

According to RP, the trial will begin January 2013. RP, as disclosed in their last 10-Q, has not taken a reserve on its balance sheet in case of a negative outcome in the trial:

It is not possible to predict the outcome of this case, and as such, we have not recorded a contingent liability as we do not believe an unfavorable outcome is probable or reasonably estimatable as of March 31, 2012.

Yardi is seeking compensation for actual damages plus punitive damages. RP has generally admitted to the facts of the claims, but disagrees with the extent of the harm. RP will have to convince a jury (assuming there is no settlement) that their employees’ use of their main competitors passwords and usernames to access their system was innocuous and caused no financial damage to Yardi.

RP currently generates, at best, a little over $30 million in free cash flow excluding acquisition costs and stock based compensation. They have $49 million of cash on their balance sheet. Any large jury award will severely impair RealPage’s balance sheet and future earnings power.

RP’s valuation implies no margin of error. They are expected to grow at plus 30% for the foreseeable future.  Management is downplaying the claims to their investors and clients for good reason. They cannot afford to take a reserve before the trial.

Any conservative reserve for the litigation would destroy their earnings and make their balance sheet look much weaker.  

This has created the perfect storm for shorts: an overvalued business with deteriorating fundamentals and a massive negative tail risk event early next year.

To say the least, I am looking forward to the trial.

Disclosure: RealPage is the largest short in my portfolio

It has been an interesting week for Diamond Foods. They missed the 180-day NASDAQ deadline to file their delayed financials. NASDAQ will likely issue a delisting letter and Diamond will ask for a review hearing.

Market participants appear to be speculating on the severity of the fraud given the delay in filing the restatement.  It is hard to know, however, what to make of the delay. I had a conversation with a friend, who is an internal auditor at a major publicly traded company. He told me, from his experience with restatements, that it could be relatively minor issues slowing the process down or it could be worse. Nobody, except insiders, really knows.

Trying to value Diamond’s equity on an EV/EBITDA basis is difficult given the lack of information. I do think, however, there are enough data points that one could use to make conservative assumptions.

If Diamond reports less then $102 million of “Consolidated EBITDA” for FY 2011, then Diamond would be in default on its agreement with Oaktree. The $102 million of EBITDA lines up with what market participants expect, with the 40 million of netted momentum payments to growers being removed from $146 million of reported EBITDA for FY2011.

Assuming the restated FY2011 EBITDA will be approximately $102 million so as not to violate the Oaktree agreement, the issue for investors is whether that $102 million is growing, shrinking or stable going forward.

As explained below, unless Diamond’s branded businesses produced significantly more operating profits, it is likely that Diamond’s EBITDA is shrinking.

Diamond disclosed in its March 13^th, 2012 press release (http://investor.diamondfoods.com/phoenix.zhtml?c=189398&p=irol-newsArticle&ID=1672088&highlight=) that  “Fiscal 2012 non-retail walnut sales were down significantly due to less supply…”

In FY2011, even after including the momentum payment, Diamond still underpaid their growers by upwards of 15 cents/lb (Growers say market discount was 45 cents/lb and momentum payment was 30 cents/lb). If Diamond had paid its growers the fair market value in FY2011, it is likely that EBITDA would have been $41 million lower or $60 million (assuming purchase of 277 million/lbs of walnuts in FY2011 with an additional 15 cent/lb discount).

The restated FY2011 EBITDA, therefore, still includes excess profits that are unlikely to be repeated going forward. This is based on Diamond’s stated goal to pay its growers fair market value for their crop to regain supply, in order to prevent Oaktree from having better terms in the recap deal.  

In addition, with supply significantly down this year, even if Diamond is still able to pay a 15 cent/lb discount, EBITDA would still go down substantially, unless you believe Kettle, Pop Secret and Emerald were able to make up for the decline.

For the sake of being conservative, however, I will assume Diamond’s EBITDA is stable at $102 million, with the decline in the nut business being made up by the branded business. I think this is a very aggressive assumption based on the commodity pressure most food companies have been facing and the slow growth in the UK and the US (the primary markets for Diamond)

The Total Enterprise Value of Diamond at the current market cap is slightly over $1 billion (409 million of equity + $225 million from Oaktree + $375 million of bank debt utilized - with an additional $100 million of borrowing capacity on the facility). 

In one of my previous blog posts, I argued that Diamond will have to tap its credit facility in order to make its final payment to growers in July for upwards of $90 million. But for purposes of this analysis, I will not assume any additional debt will be taken on by Diamond this year to fund its final grower payments in July.

Putting this all together, Diamond on a conservative basis is currently trading at approximately 10X EV/EBITDA (1.09 billion/102 million).  This is a fancy multiple for a highly levered company in a stable but mature and highly competitive category, whose cost of debt capital has increased to 12% and whose earnings could be materially lower going forward. When you consider the potential dilution from the Oaktree warrants, along with the cost of the restatement (accounting, legal, consulting and investment banking fees plus any litigation costs), the fact that the market does not have three years worth of financial data and the company might be delisted, the valuation becomes even more extreme.

Both General Mills (10.27 EV/EBITDA) and Kellogg (9.8 EV/EBITDA) currently trade for approximately the same multiple of EV/EBITDA as Diamond.  John Sanfilippo & Sons, the best comparison to Diamond’s nut business and a beneficiary from Diamond’s weakness in the business, trades at just over 5X EV/EBITDA.

So why does Diamond deserve the same multiple as General Mills and Kellogg and double the multiple as John Sanfilippo? General Mills, Kellogg and John Sanfilippo are very well capitalized, while Diamond’s balance sheet is a mess. Plus no one has any earnings visibility on Diamond.

I think the answer to that question lies in market structure that has led to inefficiency with respect to Diamond’s share price.

CEOs of publicly traded companies often complain about how short sellers are driving down their stock price. During the phase when large new short positions are initiated, the share price of a company will be under pressure. However, if all the shares available to short have been borrowed, then the shorting actually serves to keep the share price high, often irrationally so (see Sears Holdings for a prime example of this).  This is because if there are no more shares available to short, then the trading on any given day will include only long buyers, long sellers and short buyers. There will not be any short sellers.

Based on info from brokers there are only 60,000 shares (.3% of Diamonds shares outstanding) of Diamond available to be shorted at a cost of almost 40%. As of May 31^st, 10,405,616 of Diamond’s 22 million shares are being shorted, which is 47% of total shares outstanding and 52% of the total available float of 20 million shares. The short interest has been at least 10 million shares since October 14^th, 2011.

The shorts are all in and they have been so for some time. Short sellers are not what is keeping this stock down, it is what is keeping the stock up. Short selling helps keep the market efficient, but in extreme cases it leads to market inefficiency. I think Diamond Foods is prime example of the latter.

Ultimately this dynamic has an effect only in the short run; in the long run, Diamond’s share price will reflect reality. But in the meantime, it presents opportunity.

Just some food for thought.

Diamond Foods is about to have a large data dump. By June 11th in order to avoid being delisted by NASDAQ, Diamond will have to release its financials restatements for the last two fiscal years, plus the financial results for the first nine months of FY2012. That’s a great deal of info to digest. 

One piece of data, however, that will likely be missing is the size of the final payment Diamond will need to make to its walnut growers in July. It is important to remember that this was the payment last year that Diamond tried to shift.

According to some walnut growers, Diamond will have to pay close to 90 cents/lb to give its growers a fair market price for their crop this year. If you assume that Diamond bought at least 100 million lbs of walnut this year, the final payment to its growers could potentially be $90 million dollars.

This is the catch-22 of Diamond’s business. Diamond was able to show dramatic growth by grossly underpaying its captive growers (it has been estimated that since the IPO they have underpaid their growers by over $270 million). Now in order to survive they need to win them back. In order to win them back, however they need to start paying close to the actual market price for the crop. This might be good for supply but will destroy Diamond’s margins. 

And now given all the cash outflows this year that are unrelated to Diamond’s core business (see the definition of “Consolidated EBITDA” in the Securities Purchase Agreement from my previous post), Diamond does not have $90 million dollars in the bank. But because of the Oaktree recap, Diamond does now have $100 million available to borrow on its credit facility.

So in order to pay its growers, I believe Diamond will have to tap its new credit facility for close to $100 million at the end of July. The borrow rate on the facility is a minumum 6.75% (5.5% + minimum libor of 1.25%). This could add over $6 million dollars in cash interest payments annually.

Diamond’s cap structure, therefore, would include, if I am right, close to $475 million of bank debt and $225 million of Oaktree debt. Luckily for Diamond, the Oaktree debt is PIK for two years. Diamond will still be looking at approx. $30 million of cash interest payments in FY2013, plus non cash interest expense that is being compounded at 12% on $225 million (or if they meet their metrics to cancel the warrants $150 will be compounded at 12% and $75 million at 10%). 

The logic of most Diamond bulls at this point appears to be either short squeeze or that no amount of leverage is too much for a branded snack business that also has a volatile commodity business. And therefore paying over 10X EV/EBITDA for a food business is not expensive. 

If you actually do the math, however, it is pretty clear absent real growth from its branded business (prior to accounting issues Diamond’s entire growth was based on high priced acquisitions, underpaying growers and fraud), Diamond Foods’ creditors own almost 100% of their operating profit. 

And to make things worse the two main markets for Diamond are the US and the UK. The US economy is slowing and UK is in a recession. Growing the operating profits (not market share - Diamond is obsessed with market share like all lousy companies) of Kettle Chips, Popsecret and Emerald Nuts organically, and not through fraud or acquisitions, in such a bleak macro environment in a mature category will be difficult. 

A Minsky Moment has become a popular term since the financial crisis. It refers to the fact that long periods of speculation lead to a crisis. The longer the speculation the worse the crisis. Investors eventually run into cash flow problems due to the amount of debt they took on to finance their speculative investments. During a Minsky Moment the market clearing price collapses. 

Diamond, since FY2008, has increased its debt from $20 million dollars to now upwards of $700 million to finance high priced acquisitions and to meet their general cash obligations. They are levered at least 6X over “Consolidated EBITDA.” The de-leveraging that was suppose to occur after these acquisitions still has not happened. The de-leveraging that could have occurred with the recap still has not happened. At some point the de-leveraging will happen. It will happen either by the miracle of growth or by force. 

Diamond bulls: I would recommend you start eating a lot of Kettle Chips, because otherwise Diamond will have its Minsky Moment much sooner then you realize. 

There is a great deal I could say about the announced recapitalization of Diamond yesterday by Oaktree. But in this post I will focus solely on one part of the deal that has not been discussed by anyone to my knowledge. 

Diamond put together a helpful slideshow on the deal - http://investor.diamondfoods.com/phoenix.zhtml?c=189398&p=irol-presentations - but did not mention in the slides what constitutes an event of default. If I was long the stock, I might consider that important.  

If you read through the actual securities purchase agreement - http://sec.gov/Archives/edgar/data/1320947/000119312512244357/d356490dex992.htm - you will find that there is long list of potential events that could lead to default.

Here, copied verbatim, in my view is the most relevant possible event of default near term and for understanding the value of Diamond’s equity: 

(a) Failure to comply with Section 6.01(a) and (b) of the Credit Agreement as a result of failure of financial statements previously delivered to have been prepared in accordance with GAAP as result of the failure to correctly account for certain crop payments to walnut growers, and (b) other adjustments to such financial statements that may be effected in connection with the pending restatement of such financial statements, provided that the adjustments described in this clause (b) will not, taken in the aggregate, reduce the Company’s Consolidated EBITDA (without giving effect to the last paragraph of the definition thereof) for the year ended July 31, 2011 to less than $102,000,000.

So based on this clause one could assume that, as speculated after the restatement, FY2011 reported EBITDA of $146 million will shrink by approximately $40 million (netting $60 million momentum payment against prior year $20 million) to a little over $102 million of “Consolidated EBITDA”.

But like all legal agreements, the key is not the term itself “Consolidated EBITDA” but how it is defined. Without comment, I present in its full glory the the well negotiated definition of “Consolidated EBITDA,” as drafted by the lawyers of Diamond Foods and Oaktree:

“Consolidated EBITDA” means, at any date of determination, an amount equal to Consolidated Net Income of the Company and its Subsidiaries on a consolidated basis, for the most recently completed Measurement Periodplus the following, without duplication, to the extent deducted in calculating such Consolidated Net Income: (a) Consolidated Interest Charges, (b) the provision for Federal, state, local and foreign income taxes payable (calculated net of Federal, state, local and foreign income tax credits), (c) depreciation and amortization expenses, (d) other non-recurring expenses reducing such Consolidated Net Income which do not represent a cash item in such period, (e) non-cash charges or expenses related to stock-based compensation, (f) cash or non-cash charges in connection with the Third Amendment and the Oaktree Loan (including, without limitation, advisor fees, commitment fees, legal fees, amendment fees, up-front fees, and other transaction expenses) in an aggregate amount not to exceed $25,000,000; (g) cash or non-cash charges in connection with Permitted Acquisitions not to exceed $1,000,000 in any Fiscal Year, (h) the amount of purchase price and related transaction costs of any acquisition required to be expensed during such period that would otherwise have been classified as goodwill prior to the implementation of FAS 141R; provided such expenses are non-cash; (i) cash or non-cash charges in connection with the audit committee investigation and financial restatement process, including, without limitation, fees and expenses of counsel, consultants and advisors to the Company and to the Audit Committee); (j) cash or non-cash charges related to any SEC investigation or shareholder litigation (including expenses, fines and settlements), (k) employee severance and termination expenses (i) prior to December 31, 2012 and (ii) arising as a result of the termination of the Acquisition Agreement (as defined below), (l) costs incurred in connection with the Transaction Agreement dated as of April 5, 2011 by and among the Company, The Procter & Gamble Company and Wimbledon Acquisition LLC (the “Acquisition Agreement”), the transactions contemplated thereby (including the proposed financing thereof by any and each of the parties to the Acquisition Agreement), and the termination thereof in an aggregate amount not to exceed $42,000,000, and (m) restructuring or business optimization charges, costs and expenses, including, without limitation, facility closure and relocation costs and fees and expenses of operational or restructuring consultants and advisors, including without limitation, Alix Partners and human resources consultants, in an aggregate amount of all such charges, costs and expenses not to exceed $17,500,000 during any trailing four fiscal quarter period commencing after the Third Amendment Effective Date.

On May 6th, Diamond Foods announced they hired Brian Driscoll, the former CEO of Hostess Brands, as their new CEO. In the 8-K announcing the hire, Diamond disclosed that Driscoll would receive both $1.5 million worth of restricted stock units and options on the “Grant Date.” The “Grant Date” just happens to be three business days after the financial restatements are released.

http://sec.gov/Archives/edgar/data/1320947/000119312512215196/d347849d8k.htm

“To grant Mr. Driscoll a nonqualified stock option and a restricted stock award on the third business day after the date on which Diamond files with the SEC its restated financial statements for fiscal 2010 and fiscal 2011 (“Grant Date”)”

The question for the house is, why was this negotiated into the agreement? Why not just set the options and restricted stock units at the date of hire?

For example, when Diamond hired two new board members on March 7th, Diamond did not leave open the grant date. They just used the closing price of the stock at the date of the announcement. 

http://sec.gov/Archives/edgar/data/1320947/000119312512103787/d312424d8k.htm

“In addition, each New Director automatically received awards of restricted stock and a stock option under the Company’s 2005 Equity Incentive Plan. The New Directors received a grant of 4,977 shares of restricted stock, which is equal to $120,000 divided by $24.11, the closing price of the Company’s common stock on March 7, 2012.”

“The New Directors also were granted an option to purchase 10,000 shares of the Company’s common stock at an exercise price of $24.11 per share, which was the closing price of the Company’s common stock on March 7, 2012.”

If you are a Diamond bull you would argue, that the Diamond Board is now responsible corporate citizens. They are looking out for the interest of its shareholders. The stock is going to fly upwards after the restatement. Lets make the CEO actually work for his money, rather then giving him free money with options and restricted stock at such a low strike price at the date of hire. 

You would also argue that the Key Executive Retention Plan given on Feb. 24th for the four top executives, who are clearly exemplary employees and had no knowledge of the fraud, was a different situation. Diamond needed to keep these employees. They could not wait till after the smoke clears to grant them new bonuses. Their new restricted stock units had to be calculated just two weeks after the audit committee announcement on Feb 8th, otherwise these great employees might have left the company. The new CEO Brian Driscoll did not have the type of leverage over the Board as these key employees.

http://sec.gov/Archives/edgar/data/1320947/000119312512078071/d306582d8k.htm

If you are bear, like me, you say nice job Driscoll on the negotiating tactic. You just quit on one bankrupt company after they balked on your executive compensation. (http://online.wsj.com/article/SB10001424052970204781804577271502269079914.html). Now you were able to get hired at another company that also needs to be restructured, but this time the Board gave you $1.5 million restricted stock and $1.5 million worth of options without a fuss. Unlike those pesky guys at the Hostess employee union and the federal bankruptcy watchdog, who complained about your pay. 

And not only that, the Board was so desperate for a new CEO, they were willing to frontdate your options and restricted stock. Why would you want your options and restricted stock at the current price. You do not want to touch this thing even at the current price with other peoples money. You are going to get your free look at this stock after it collapses.

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Diamond is one of the mostly heavily shorted stocks. If the restatement causes the stock to go higher, then there would likely be an epic short squeeze - remember the stock went from $26 to $40 in December because the great Akshay Jagdale at Keybanc comment that everything was fine at Diamond. It would be kinda of funny, if Driscoll got his restricted stock and options at a price that is irrationally high because of a major short squeeze.