Description

This is a short idea. 

Brief Company Description

Formerly a walnut co-op, DMND processes and markets branded nuts and snack foods under the Diamond of California, Emerald and Pop Secret brands.  On March 31, the company acquired potato chip maker Kettle Foods from private equity firm Lion Capital for $615 million.  Going forward, revenues will be approximately 60% nuts (snack and culinary), 30% potato chips and 10% popcorn.  Potato chips should contribute almost half of DMND's EBITDA, assuming >20% EBITDA margins in this segment are sustainable. 

Inflated Earnings

DMND has been over-earning during the past year, as gross margins have reflected a record drop in wholesale walnut prices.  While accurate sources of walnut pricing are not broadly available, this decline has since reversed according to industry sources and the occasional press report, with wholesale pricing rising close to 50% this season compared to the prior year.  I expect higher ingredient costs, at some point, to put a large dent in DMND's reported gross margin.  DMND has been able to hide the price drop to date through lenient accounting standards which allow DMND to delay estimating its cost of goods until the end of the walnut selling season (April/May), when DMND and its retailers determine pricing for the following year.  Typically, DMND would record an adjustment each quarter (see the catch-up last year which added $10m to Q3 pre-tax profit), so we could see such an adjustment in the coming months when Q3 (ends 4/30) is reported. 

See following 12/26/09 LA Times article for some color on walnut pricing over past two years, which ties with what I have heard from various California walnut growers and handlers:

Excerpt:

"Jerry Barton, a Ripon walnut grower whose family operates Gold River Orchards, a nut processor in Oakdale, said he had never seen as severe a price drop as in November 2008 or as strong a recovery as this year."

In the following table, I have tried to isolate DMND's historical gross margin, stripping out the Pop Secret business (acquired 9/15/2008).  Pop Secret was expected to add $85-90m in sales at 30% gross margins, and from what I can gather, this business is still doing about this level of sales and gross profit.  Stripping it out, we see that the nuts business earned much more than usual in 2009, and that it was forecasted to continue this trend in 2010. 

2010E reflects approximate consensus before the Kettle deal (which closed 3/31/2010) was factored into 2010E numbers (so does not include Kettle's results for April-July, although these will be included in reported results).  The implication is that 2009's gross margin of around 22-23% in the core nuts business was assumed to be sustainable by the sell side.  This is not a small assumption - if we were to assume a more "normal" gross margin in the nuts business, in line with history (say 14-18%), then $25-45m of pre-tax profit is at risk.  The midpoint is equivalent to over half of 2010E consensus. 

Caveat: the Diamond culinary business and "non-retail" nut business, combined, have been shrinking, whereas the Emerald snack business has been growing quickly off a small base.  This mix shift has contributed to increasing gross margins.  However, Emerald is still less than 25% of sales (before factoring in the Kettle acquisition), so this explains only a small part of the margin shift within the nut business. 

Poor Relationships with Suppliers / Litigation Risk 

In addition to rising costs, the walnut business is plagued by strained supplier relationships and outstanding litigation by suppliers alleging that DMND has underpaid suppliers in several recent years.  These lawsuits have been disclosed only minimally, consistent with management's generally promotional communications and disclosure.  One would expect that a former co-op would have good relationships with its former members, but conversations we have had with multiple growers and former co-op members imply that this is not the case.  At the very least, the walnut business should have trouble retaining many of its suppliers as contracts entered into around the time of the IPO continue to roll off. 

Growth By Over-Paying 

Part I: Pop Secret

DMND has made two major acquisitions since going public, and both seem unfavorable.  In the case of Pop Secret, DMND claimed to have paid General Mills a reasonable 7x EBITDA for the business; the catch is that they paid 7x gross profit, assuming they could provide virtually zero sales, marketing, general and administrative support.  I estimate they actually paid 2.1x Sales and over 10x EBITDA.  They recently attributed increased G&A and advertising spend, in part, to "supporting" Pop Secret, which they also are finally admitting has not grown (and may have shrunk).  The microwave popcorn business presents many challenges, including problematic packaging and health risks to employees and frequent customers, with few offsetting opportunities for upside or growth.  Disclosure has been murky since the acquisition, and the company has been unwilling to disclose how the acquisition has performed with any significant detail, instead combining the popcorn business with the Emerald snack nut brand in segment reporting.  This was certainly a bad deal and poor use of capital.  Timely windfall profits in the nut business are the only reason the initial leverage did not become unmanageable. 

Part II: Kettle Foods

The recently closed Kettle Foods acquisition seems equally unattractive.  Kettle's rapid EBITDA margin expansion to high absolute levels (from 16% to 21% over the past three years) suggests that the business was being groomed for exit by its financial sponsor.  Meanwhile, according to press reports, DMND outbid much larger and better-capitalized concerns (Pepsi/Frito-Lay) and potato chip market incumbents (Lance, maker of the Cape Cod brand) in order to "win" a highly competitive auction, paying about 2.4x sales and 11x EBITDA for the privilege.  As a result, DMND finds itself leveraged at 4.5x pro forma EBITDA, and facing a leverage covenant of 4.75x (which declines); the company has essentially bet its future on this seemingly incongruent acquisition.  I believe management may have rushed to close the Kettle acquisition in order to obscure the sharp increase in walnut costs, and as a result I expect the upcoming April quarter report to be a mess, potentially to the point where the sell side and investors give the company a pass.  However, whether or not problems at the core business are immediately apparent, going forward the company will be saddled with a weakening core business, two overpriced acquisitions and an overleveraged balance sheet.  With the stock currently trading for over 12x pro forma 2010E EBITDA and over 1.7x Sales, I don't think the stock price remotely reflects these risks, and see fair value around one third of the current quote (would imlpy 1x Sales and 7x EBITDA, close to where LNCE trades)... assuming the newly leveraged balance sheet does not become an even bigger problem, and generously assuming continuation of historically high gross margins in the nut business. 

If we assume a "bear case", where the nut business goes back to an 18% gross margin (still quite high), Pop Secret does not shrink, and Kettle grows top line 12% and maintains a 21% EBITDA margin (still aggressive assumptions), then we might be looking at 2011E EBITDA of $110m, implying leverage of 5.6x and valuation of 14x EBITDA and a P/E nearing 30x.  Take 14% for nuts gross margin, and it's more like 17x EBITDA, and leverage over 6x.  In either case, leverage quickly becomes an issue: the leverage covenant is tight, starting at 4.75x, vs. current leverage around 4.5x (2010 pro forma numbers). 

Other Minor Reasons to Expect Management to Do Better Than Shareholders

Annual Super Bowl ads (and bad ones at that)

Annual bowl sponsorship (Emerald Bowl)

Repeated CEO appearances on Jim Cramer's Mad Money

Stated plans to grow by acquisition (and a board that seemingly loves to "win" auctions)

Poor disclosure - look for Kettle to be lumped in with Pop Secret and Emerald, making it more difficult to track whether or not Kettle performs as promised

They have thrown underwriting business to the least friendly analysts, perhaps to buy their silence? (BMO was joint book on recent financing - theirs was the only analyst who historically really asked about the walnut cost accounting adjustments)

Risks

Short interest is already 14% of the float, so I am not the first person to spot flaws in this DMND (ugh). 

Leverage cuts both ways - if they somehow can make more money in each of their brands than any of their competitors (Kraft, ConAgra, Pepsi, Lance) and/or brands' prior owners (General Mills), then debt reduction would eventually accrete to the equity, and over time DMND might grow into (or even beyond) its valuation. 

Takeout?  Despite the history of consolidation in branded packaged foods, I am not worried about a takeout - they already have paid top dollar at auction for most of their business, and nobody wants the walnut buisiness (including DMND, it seems, given their seemingly urgent diversification). 

Catalyst