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.