Random Thoughts On My Investments

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.

____

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.  

During my short investment career, I have tried to avoid writing or commenting about stocks in any public forum. I have, however, made an exception for Diamond Foods - and now going forward I have decided to post on my tumblr account thoughts about my investments, if I truly have something unique to say. Whitney Tilson, I hope you are reading this. 

Diamond Foods has been an obsession of mine now for almost a year. And lately I have been commenting on any article written about Diamond Foods on Seeking Alpha.

For my many followers on Tumblr (I am looking at you “dumbmoney”), I thought you would enjoy reading some of my recent comments on Diamond Foods on Seeking Alpha. 

http://seekingalpha.com/user/1117177/comments

And just for a historical record, here is my first comment about Diamond Foods, on the “great” investment site the Motely Fool.

http://www.fool.com/investing/general/2011/11/04/dont-go-nuts-over-diamonds-recent-fall.aspx

Diamond Foods is currently in the process of restating the last two fiscal years of its financial statements. The focus of the restatement is the shifting of Diamond’s grower expenses to future years. (http://investor.diamondfoods.com/phoenix.zhtml?c=189398&p=irol-newsArticle&ID=1658627&highlight=).

In this post, I would like to focus on Diamond Foods’ capital expenditures as they relate to three Kettle Food plant expansions announced from August 2010 through February 2011.

The total announced value of the expansions was $56.4 million: $8.4 million at the Salem, Oregon plant announced in August 2010 completed in April 2011; $38 million at the Beloit, Wisconsin plant  announced in November 2010 and to be completed in the first quarter 2012; and $10 million at the Norwich, UK plant announced in February 2011 that was to be completed by November 2011, but was pushed back until 2012.

The market and the news media seems to be assuming that the fraud at Diamond is limited to shifting expenses forward. I think this a big assumption. Often in cases of shifting expenses, a company also looks to hide the expenses on their cash flow statement and balance sheet. 

One great place to hide expenses is in growth cap-ex (i.e. WorldCom). Therefore the aggressive growth cap-ex, announced and being completed during the period of the grower underpayments, should be viewed critically. 

Diamond completed its purchase of Kettle Foods in March 2010. As part of the total purchase price of $616 million, Diamond allocated $66 million to property, plant and equipment.

That means within one year of owning Kettle, Diamond announced the purchase of property, plant and equipment worth 85% ($56/$66) of the amount of property, plant and equipment acquired. Even though on the conference call in Feb 2010, Steven Neil, the former CFO, said that there is not going to be significant capital requirements at Kettle near term. He mentioned that Lion Capital had just doubled capacity in Beloit and the UK plant had just put in for a capital spend on building a multipack line.  (http://investor.diamondfoods.com/phoenix.zhtml?c=189398&p=earningsReleases).

In 2006 Kettle’s original owners spent $2 millon on equipment to increase capacity by 30% at the Salem plant. (http://www.businesswire.com/news/home/20060130005240/en/Kettle-Foods-Announces-Major-U.S.-Expansion-Midwest). Diamond, however, announced a 25% expansion in Salem that would cost $8.4 million and later told Reuters that the cost came in at closer to $9 million (with 70% being equipment cost and 30% being construction costs). It seems strange that a 30% expansion cost $2 million in 2006, but in 2010-11 Diamond had to spend reportedly $6.3 million (70% of $9 million) on equipment for a 25% expansion.

It should also be noted that Diamond in filings with the City of Salem claimed that the equipment cost would be $7.2 million and construction costs would be $1.2 million. (http://www.cityofsalem.net/CouncilMeetingAgenda/Documents/192/4.2b.pdf). Therefore, as proposed, the expansion was supposed to be 85% equipment and 15% construction. The original $1.2 million construction cost numbers also lines up with the total value of construction permits filed with the city. (https://splash.cityofsalem.net/AMANDA5/eNtraprise/Salem/public/public_folder_permit.jsp?clicked=searchByOther).

The entire cost of building the Beloit plant from an empty piece of land in 2007 was $20 million. (http://www.businesswire.com/news/home/20060130005240/en/Kettle-Foods-Announces-Major-U.S.-Expansion-Midwest). Yet they announced a massive $38 million expansion to double the size. Even more strange the private equity firm Lion had just doubled the capacity in Beloit in December 2009 for a cost of $8 million. So it cost $20 million to build and equip from scratch the entire facility in 2007, $8 million to double capacity in 2009, but $38 million in 2011 to double capacity again.

 Diamond’s press release announcing the $10 million ( £6.8 million pounds) expansion at the Norwich, UK Kettle plant provided very little info on the scope of the project. The release simply said the expansion included new multi-pack lines and an enhancement of employee facilities. (http://investor.diamondfoods.com/phoenix.zhtml?c=189398&p=irol-newsArticle&ID=1522324&highlight=). News reports in England suggested the project could create 35 new jobs. (http://www.foodmanufacture.co.uk/Manufacturing/Crisp-competition-drives-Kettle-expansion).

In an annual report filed with the International Chamber of Commerce in the UK, Kettle Foods Ltd. (Kettle’s UK subsidiary) reported total tangible assets of £17.8 million pounds as of July 31, 2010. Therefore the £6.8 million pounds expansion would increase Kettle’s tangible assets in the UK by nearly 40%. Considering that Diamond did not specify the amount capacity would be expanded, as it did in the press releases announcing the Salem and Beloit expansion, such a large increase in Kettle UK’s asset base is surprising. 

Diamond’s cash flow statement for the quarter ending April 30, 2011 is instructive because at that date all the costs from the Salem expansion should have been incorporated into the financial statement, as it was completed prior to the end of the April quarter.

For the nine months ending April 30, 2011, Diamond reported spending $15.195 million of cash flow on property, plant and equipment.

If the equipment cost at Salem was 70% of the $9 million expansion cost then the equipment should account for approximately $6.3 million of the total cost.   Diamond, however, leased all their equipment for the Salem expansion under an operating lease agreement with GE Capital that was assigned to Bank of America on March 8^th, 2012.  (https://secure.sos.state.or.us/ucc/doFileNumberSearch.action?lien.fileNumber=8776974).

Operating leases are setup as a financing arrangement whereby both the asset and liability are kept off the balance sheet.  It would allow Diamond to get access to new equipment for the Salem plant for low monthly cash outlays, instead of a large upfront cash payment. Therefore the $6.3 million of equipment for the Salem plant would not appear on Diamond’s cash flow statement for purchases of property, plant and equipment. The monthly lease payments should be flowing through the operating expense line. 

The $10 million (£6.8 million) expansion in Norwich, UK was announced in February 2011, three months before quarter end. They did not file their first building permit for the expansion until July 2011. (http://www.norwich.gov.uk/Planning/Documents/Weeklylist27090711.pdf).

In addition, Diamond told Reuters in February 2012 that work was still under way in Norwich.

 It is unlikely, therefore, that any of $10 million cost of the Norwich expansion would be included in the $15.195 million spent on property, plant and equipment by April 30, 2011.

 As for the Beloit expansion, Diamond took on a $21 million dollar equipment loan for the Beloit plant. That amount was deposited in a restricted cash account. As of April 30, 2011, the restricted cash line on both the balance sheet and cash flow statement still showed $21.4 million, or the entire amount of the equipment loan. This means that Diamond still had not made any purchases of equipment for the Beloit plant out of the their equipment loan. Diamond did not file its construction permit ($7.5 million assessed value) until April 12, 2011 with the City of Beloit. (http://muenster.ci.beloit.wi.us/wedge/view/parcel/23222000). Therefore, unless they bought a large amount of equipment outside the equipment loan, it is likely that a great deal of $38 million cost of the expansion was spent after April 30^th, 2011.

The $15.195 million, therefore, looks strange considering that the only expansion that had been completed was in Salem and 70% of the $9 million cost of the Salem expansion was paid for through an equipment operating lease. If you assume Diamond spent $2.3 million on construction costs in Salem (30% of $9 million) then that would leave nearly $13 million remaining on the cash flow statement that is unaccounted for.

 It is important to note that for the year ended July 31, 2011, Diamond reported on their 10-K that they spent $27.7 million of cash on the purchase of property, plant & equipment. That is approximately $12.5 million in the last quarter of FY2011 (27.7-15.2). Of that $12.5 million, $5.4 million was spent from the equipment loan for the Beloit expansion in the last quarter of FY 2011. That leaves $7 million remaining. Based on the timing of the Beloit construction and completion, I expect that $7 million was mostly Beloit construction related.

The purpose of this analysis is simply to raise questions. Diamond’s auditors are likely doing a full forensic audit prior to allowing the release of their restated financials. I expect those restated financials to provide clarity with respect to Diamond’s cap-ex.

 Disclosure: I currently own put options that will profit if Diamond Foods’ stock continues to fall prior to the put option expiration date.

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