Description

Diamond Foods (Ticker: DMND) embodies two tried and true value investing themes.  First, it has two distinct business lines, one (Emerald) that is growing quickly but operating at a somewhat substantial loss (for now), thereby obscuring the earnings power of the much larger second business (Diamond).  Second, last year it converted from a cooperative to a for-profit entity, and thus the true earnings power of the business is not readily apparent based on a quick study of historical results both because of coop accounting and the prior lack of a pure profit motive.  As an added bonus, the sell-side analysts covering the story do not seem to understand it well (they’re obsessed with quarterly growth figures at Emerald), and the somewhat understandably negative reaction to the recent pre-announcement is creating an opportune entry point.  The topper is that there has been pressure on gross margins recently as nut prices are at historically high levels, and as those prices revert to historical norms profitability should improve.

 

The punch line is that I believe at the current price you are buying the market-dominating Diamond culinary nuts business at a modest discount to its intrinsic value and you are getting the high-growth (the company anticipates that sales will double next year) Emerald nut business for free.

 

--  The Conversion

 

Until July 2005 Diamond Foods (“DMND”) operated as a cooperative, owned by a number of walnut growers in California.  It had been founded as Diamond Walnut Growers, Inc. in 1912 and was committed to finding buyers for all of its members’ crops.  This commitment resulted in some production being sold at sub-optimal margins.  In early 2005 DMND began the process of converting to a C-corporation, and on July 20, 2005, Diamond Foods sold 6mm shares at $17 in an IPO.  Since that time they have been gradually weaning themselves off of certain lower margin international sales and working on growing Emerald.  Unlike some other cooperative conversions (CF Industries comes to mind), the main driver behind the offering was not the desire for liquidity by the cooperative members ($17.3mm was distributed to growers, and they received just over 8mm shares), instead it was to raise capital to help grow DMND’s Emerald line of nut-based snacks.

 

--  Two Segments: Diamond and Emerald

 

While Diamond reports its results as one segment in a few different channels, in reality DMND has two separate businesses represented by its two brands: Diamond brand nuts sold for culinary and other consumption, and Emerald brand nut-based snacks.  The July 2005 prospectus contains an excellent overview of the company and the industry, and the company has presented at a couple of conferences as well (you can find their most recent slides in a July 12th 8k).  Below is a quick summary.

 

Diamond

 

The Diamond segment, as I define it, includes everything but the Snack business as reported by the company (which sells under the Emerald brand).  Diamond accounted for approximately 93% of the $468mm in LTM sales (4/30/06) at DMND.  I lump Diamond into two main buckets: Culinary/In-Shell and International/Ingredient.

 

- Culinary/In-shell – The largest piece of DMND’s reported results is the Culinary segment, which represents sales of the market dominating Diamond brand ($185mm, or 39% of DMND’s total as reported in the financials).  Culinary includes nuts (primarily walnuts, pecans and almonds) sold in grocery store baking and produce aisles.  In the last twelve months Culinary sales have grown 17% as Diamond has taken market share and increased prices to offset higher nut costs.  In-shell nuts, which accounted for roughly 10% of LTM sales, are sold primarily during the winter holiday season.  On a combined basis, the culinary and in-shell nut businesses are estimated by IRI to total $600mm in the US, growing at about 4%.  Diamond has roughly a 39% market share (from company slides).  The next closest “competitor” is “all private label brands” at 17%, followed by Planters (9%) and John B. Sanfilippo & Son (2.4%).  The balance is a collection of regional brands.

 

- International/Ingredient (I&I) – International is the second largest component of Diamond ($110mm, or 20% of total DMND), but that and Ingredient are both shrinking in FY2006 as a new base is set.  An example customer within the Ingredient segment is McDonald’s, which purchases Diamond glazed walnuts for a salad it offers.  I&I includes something of an “annuity” portion (company’s words) that sells high specification nuts to Japan (due to growing conditions and farming talent California walnuts are the world’s best, and DMND controls the largest chunk of that crop).  Management estimates that 80% of I&I is pretty well locked in.  The other 20% of I&I is low-margin and very price sensitive.  When DMND was a cooperative, I&I is where the last of the low-quality walnuts from the growers would be “dumped” at below-average margins to extremely price-sensitive buyers.  This portion of the business is being phased out as the focus shifts toward making more profitable sales.  In order to get to management’s guidance, I&I sales are projected to decline by about 15%, virtually eliminating the lower margin sales.

 

Emerald

 

Emerald is an emerging player in the approximately $2.6 billion snack nut market, a figure that grew roughly 3% in 2005 (which followed on the heels of 2004’s 15% growth) as consumers continued to shift towards “healthier” snacks.  Emerald accounted for approximately 7% ($31mm) of DMND’s LTM sales.  Emerald was initially launched on a small scale in 2001, and sales hit an inflection point in DMND’s 2005 fiscal year (ended July), more than tripling to $22mm from $7mm in 2004.  Emerald sponsors a college football bowl game in San Francisco, has been an advertiser on each of the last two Super Bowls (this year’s was weak IMO) and sponsors running events and other “healthy lifestyle” events.  Emerald’s more than 60 SKUs are positioned and priced as premium nut products.  While it does offer a peanut product (Planters’ unquestioned strong suit), it is a small part of the business.  Emerald differentiates itself with higher quality tree nuts, unique ergonomic packaging and a proprietary glazing process (leading to flavor enhancement) that extends shelf life by keeping oxygen out of the process.  [If you look at DMND as a long, I recommend trying the Chocolate Brownie Glazed Walnuts or the Breakfast Blend Trail Mix.  If you’re looking at DMND as a short, try the Pecan Pie Glazed Pecans.]

 

Planters dominates the snack cut category, enjoying a 34% market share.  28% of the market is private label, and Emerald is currently at 3.6% nationwide (though they are stronger on the coasts).  A data point that DMND trumpets is its 14% national market share in the “mixed nuts” segment with a single SKU.  Emerald’s express goal is to establish itself as a strong number two in the national market to Planters (a position not really occupied by anybody today).  That won’t happen overnight.  The business is clearly early in its development, however it has a couple factors working for it that other start-ups do not.  First is the channel relationships established via the Diamond brand.  While it is always driving to improve shelf positioning and SKU count, DMND has at least one Emerald SKU in 83% of all grocery stores.  A second important factor helping Emerald is the relationships with the walnuts growers, providing it access to premium walnuts and expertise in production.

 

--  Recent Guidance and Acquisition

 

The recent gap down in the stock (on May 10^th) was a result of DMND reducing guidance for its fiscal year ending July 2006.  The guidance was reduced as follows (all “current” guidance excludes the effect of the Harmony acquisition, $ in millions except per share):

 

                                     Previous                Current

Revenue                   $486 - $509           $465 - $472

Snack revenue                $43+                  $33 - $36

NA retail growth         25 – 30%                   18%

EPS (excl-stk comp)  $0.85 - $0.91         $0.59 - $0.65

 

The main driver of the revenue shortfall in retail came from the Snack business.  Based on my discussions, management believes this shortfall did not result from product turning slower than anticipated, rather it was driven primarily by a delay in Emerald’s rollout into the mass merchant channel (specifically at Target and Wal-Mart).  Management did an awful job communicating this point to the street – as recently as two months prior they were indicating that snack sales would “more than double” over 2005’s figure.  Yet my conversations indicated that it was hoped that Target would have had a full rollout by January, so sticking by the guidance as long as they did is puzzling at best.  While neither the slip in timing nor the botched communiqué is positive, DMND did announce a number of new SKU “wins” at Target, Publix and Nash Finch.  Target is more than doubling its SKU count (from 2 to 5), and these SKUs should be in before the end of DMND’s fiscal year.  That is important because it should both lay the ground work for increased sales in F2007 and also deliver the brunt of the slotting fees into F2006 (slotting fees are “paid” up front and are accounted for as contra-revenue).  Management believes that its trials at Wal-Mart, which started in 100 stores, has gone up to 400 stores and now also includes auto-replenishment, are going well.  DMND is also in talks with Costco, Sam’s Club and BJ’s, which represent large opportunities.  On the Q3 call in early June the company announced further distribution into BJ’s Wholesale Club, Kmart, Circle K, Meijer, and Seven-Eleven.

 

Depending on how you look at it, a concern (if management fails to deliver again) or a silver lining (if they hit the guidance) is that DMND management guided to Emerald/Snack revenue “in excess of $80mm” for F2007.  $10mm of that is expected to come from the Harmony acquisition (the Harmony products will be re-labeled Emerald with a Harmony sub-brand), so ex-Harmony the Snack segment is forecast to approximately double in F2007.  Terrific if it happens, but it would mean that growth went from 203% in 2005, down to 55-70% in 2006, and back up to 100% in 2007.  The number is not implausible, as the wider distribution at mass, which represents a much larger portion of the snack nut business than grocery’s 1/3 share, will no doubt help tremendously.  Harmony growth is another opportunity.  Management’s responses, though, reveal that $80mm is far from “dialed in” (if sales of this sort are ever dialed in), and details are soft on how they think they can get there.  DMND really doesn’t need another disappointment on the snack sales front, but that number is now out there.

 

The Harmony Foods acquisition that was announced coincident with the guidance reduction is a mild positive.  Most important to the deal is the acquisition of a 187,000 square foot facility in the Midwest at a price that management believes is a fraction of what a greenfield facility would have cost.  The acquisition added packing capacity and yogurt-coating capabilities for its trail mix.  Management will also take the Harmony brand and attempt to gain wider distribution within its grocery base, as Harmony is currently distributed in only 30% of the US.  DMND also announced they expect $2mm in cost savings as a result of the deal, meaning that at absolute worst they paid 9x EBIT on cost savings alone.  Harmony, however, is not central to the thesis, and that is a good thing because I recently tasted the product and I thought it to be terrible.

 

--  Nut prices

 

Nut prices are at historically high levels, and that is clearly impacting profitability across the industry.  Previous post John B. Sanfilippo & Son (JBSS) is running at a low single digit gross margin (though there are reasons other than just nut prices for this), and Ralcorp’s (RAH) private label snack nut and candy division’s operating margins are down more than 600 bps year over year.  Industry data that I found shows almond prices were double the past ten year average in 2005, and pecans were up over 50%.  To be fair, DMND’s revenues are roughly 2/3 walnuts, which weren’t up as dramatically as almonds, and walnuts are believed to be the most stable of the tree nuts.  That said, according to the company it paid growers the highest value per acre of walnuts in its history (some of it no doubt due to higher yields, but still a data point).  The path of future walnut prices will be determined in large part by the global crop, something the company has no control over and I have no expertise in (commentary is welcome).

 

--  Valuation

 

The key to the DMND story is understanding that the growing but unprofitable Emerald business is obscuring the profitability of the Diamond business, and that both pieces are suffering from historically high (but eventually declining and/or being offset with price increases) nut prices, which should lead to gross margin expansion as prices normalize.  The company does not break out Emerald’s financials (they only report sales by channel), but it is not too difficult to construct what Diamond and Emerald income statements would look like in 2006 (FYE July) and in 2007, as nut prices begin to recede to historical levels, by studying the past financials and badgering management.

 

Diamond

 

--  Sales – 2006: $435mm; 2007: $446mm.

Total sales guidance for FY2006 is for $465-472mm (excluding Harmony).  Emerald is projected to do $33-36mm.  That puts Diamond sales at roughly $435mm for 2006.  Management estimates that the culinary business is growing at 4% per year, and that they took about 1.5 points of market share in the past year in part by picking up a 450 store account.  So for 2007 I grow culinary and in-shell by 5%, and keep international and ingredient flat, getting me to the $446mm.

 

--  Gross profit – 2006: $66mm (15.3%); 2007: $71mm (16%)

The 15.3% gross margin in 2006 is backed into based on a few data points.  First, in order to get into management’s EPS guidance, I estimate the blended gross margin at 14.9%.  According to management Emerald is running well below that level, as capacity is underutilized and slotting fees are still being incurred for new distribution.  I estimate a gross margin of 10% for Emerald based on the magnitude of their operating losses, leaving a 15.3% gross margin for Diamond.  Management has estimated that with nut prices at more “normal levels,” the non-Emerald business should run at a 17-18% gross margin (in fact management said “there’s no reason we wouldn’t get to that point or better”) – I use 16%, which is actually below the low-end, for 2007 to be conservative.

 

An example illustrates the impact nut prices can have.  Almonds, which have historically sold for between $1-2/lb and averaged $1.54/lb from 1993 to 2004, sold for well over $4/lb at points during the last twelve months.  According to management they are now below $3, and if they were to fall back to $2, almonds by themselves (allowing for DMND’s easing in its own prices that would result) could provide up to an 85 bps pick up in gross margin.  This is despite walnuts accounting for 2/3 of all sales.

 

Another tailwind in Diamond’s gross margin will come from re-pricing their Ingredient contracts, which are annual and run from November to October.  Also, the $2mm in cost savings from Harmony should show up here.  Potential headwinds are the size of the walnut crop (a smaller crop could pinch prices upward) and integration snags at the Harmony facility.  And for reasons I don’t grasp (conservatism?  finally?), management plays down the possibility of “meaningful” gross margin expansion from lower raw material costs in F2007.

 

--  SG&A – 2006: $30.7mm; 2007: $31.6mm

The $30.7mm is a relatively conservative estimate I come up with for Diamond based on an analysis of the past financials, when Emerald was a tiny piece of the business and DMND was still being run as a cooperative.  SG&A averaged $27.6mm from 2001 to 2004, and the $30.7mm allows for public company costs, additional brokerage fees due to higher volumes and general inflation.  For 2007 I grow Diamond’s SG&A at 3%.

 

--  Advertising – 2006: $9mm; 2007: $9.3mm

Again, I estimate advertising for the Diamond brand (which relates to the culinary business) based on historical financials, before advertising for Emerald really began to launch in FY2004.  For 2007 I grow Diamond’s advertising at 3%.

 

--  Interest expense – 2006: $1.5mm; 2007: $1.5mm

I allocate all of the interest expense to Diamond, and management has guided to $1.5mm for FY2006.  I keep it flat for 2007, as the increase in debt from the Harmony acquisition should be offset by cash flow.

 

I use a 40% tax rate and 16.3mm fully-diluted shares (which includes RSUs, but no impact from the roughly 1.5mm options because they are struck at $17.61) to get the below EPS figures.  Maintenance capex is roughly equal to depreciation, so EPS isn’t a bad estimate of cash flow.

 

--  Diamond EPS – 2006: $0.93; 2007: $1.07

 

Diamond Foods’ current stock price (I use $15) thus implies that you are buying Diamond for 16.2x current FY earnings and 14.0x 2007E earnings, which should rise as gross margins rebound.  At 17% gross margins (the low end of “normal”), Diamond’s EPS rises to $1.23 and the multiple falls to 12.2x (EV/2007 normalized EBIT of 7.5x).  So what’s the right multiple?  Branded food businesses typically trade mid-to-high teens, however they do not generally have the seasonality or raw material risk that Diamond has.  A decent comp is John B. Sanfilippo & Son, however that is mostly private label, which makes it far more difficult to pass through price increases.  It is also run like a private company for the benefit of family and friends, but I digress.  Historically John and his Son haven’t garnered much more than a low double-digit P/E, but it has a decidedly less advantageous product mix (more peanuts and private label).  Diamond has a dominant market position in the culinary segment, and also has locked up ~40% of the California walnut crop via contracts with growers.  If you conservatively burden Diamond for all of the capital investment in the business (net working capital has averaged $83mm over the last four quarters, while net PP&E stands at $29mm), it would generate a 28% pre-tax return on capital based on 2007E figures, so it is a “good business” (though not great).  Let’s just say that at 12.2x normalized earnings you’re paying a “fair” price for Diamond.  I would argue that given its market position it is worth 15x the normalized 2007 figure of $1.23, or $18.

 

Emerald

 

OK, so Emerald is free (or we are getting paid to own it)….but what do we really get for free?  I estimate that Emerald will lose around $9mm this fiscal year as it continues to incur slotting fees as customers and SKUs are added and it bears the burden of excess packaging capacity (management believes that current capacity could handle almost $250mm in sales).  [Editor’s note: If it turns out Emerald is losing more money, that means that Diamond is more profitable than I’ve laid out.]  It’s also advertising at a robust clip of about 35% of sales.  The future is bright though.

 

The last four quarters have seen year-over-year sales gains of 278%, 193%, 147% and 51%.  For all of fiscal 2006 sales are expected to rise 55-70%, and management estimates that sales could double in F2007.  Currently two-thirds of Emerald sales are made in the grocery channel, aided by the strength of the relationships built through the Diamond brand.  (According to a competitor, the Emerald brand has been performing exceptionally well in that channel, better than most expected.)  However the grocery channel accounts for just 1/3 of all snack nut sales, and as Emerald further penetrates the mass and club channels (Sam’s is a large culinary customer) and continues the roll out of its snack mix SKUs, sales growth should remain very strong.  The company has announced a number of new account wins recently.  It is this dynamic, the saturation of the grocery channel and the move to the next leg of growth in mass and club, that helps explain the deceleration and reacceleration in Emerald’s sales.

 

--  Sales – 2006: $33mm; 2007: $67mm

I grow sales at 100% in 2007, but excluded the $10mm from Harmony to be “conservative.”  Again, DMND has guided to sales in excess of $80mm.

 

--  Gross profit – 2006: $3.3mm (10.0%); 2007: $8.7mm (14.5%)

I back into my gross profit estimate by assuming that Emerald will lose about $9mm in 2006.  Management wouldn’t discuss a specific number, but they did say this was not a bad estimate.  The gross margin is low because slotting fees that are incurred to get into certain retailers show up here, as does the excess capacity that has been added in anticipation of a sales ramp.  2007 should see a significant gross margin ramp as excess capacity is chewed up and slotting fees are lapped.  Eventually, whether it be in DMND’s F2008 or F2009, Emerald will run at a materially higher gross margin (20%+) than Diamond, so the F2007 is not all that meaningful in the grand scheme.

 

Aside: I do believe that Emerald has the potential to break-even if it delivers the $80mm in sales management has put out there.  That would translate into incremental margins of only ~20% on the 2007 sales increase, and would infer gross margins of 17+%.  Importantly this could lead to DMND generating EPS of over $1 next year, but many things would have to go right to get to this number.

 

--  SG&A – 2006: $0.3mm; 2007: $0.7mm

In order to be conservative on Diamond’s valuation I allocate almost all of the SG&A to that business (this is supported by historical financials).  What shows up here is a purely variable 1% of sales distribution fee.

 

--  Advertising – 2006: $12mm; 2007: $13mm

I get Emerald’s advertising expense by backing Diamond out of the total.  I assume that it increases marginally in 2007.

 

I use a 40% tax rate and 16.3mm fully-diluted shares (which includes RSUs, but no impact from the options because they are struck at $17.61) to get the below EPS figures.  Maintenance capex is roughly equal to depreciation.

 

--  Emerald EPS – 2006: –$0.35; 2007: –$0.15

 

With negative earnings for 2007, I would look to two alternative measures of valuation.  The first is applying a revenue multiple based on the price that Hershey acquired Mauna Loa Macademia Nut Corp. in November 2004.  Hershey paid a total of $130mm for $80mm of revenues, or 1.625x sales.  Using my 2007 revenue estimate (which is 16% below management’s guidance) implies a valuation of $109mm or $7 per share.  (Editor’s note: anecdotally, Hershey has allegedly lamented overpaying for Mauna Loa.)

 

Another approach is to look at DMND’s stated market share and margin goals, and then apply a healthy haircut.  DMND estimates that the snack market is $2 billion at wholesale, and that their goal is to achieve 10% market share (they’re already above 7% in California).  Their stated long-term operating margin goal is 10%, so I give the higher gross margin Emerald business a 12% operating margin.  I stick my thumb up in the wind and give them a 50% chance of hitting that, which gives them expected operating earnings of $12mm.  Tax effecting that and applying a 17x P/E gives a probability weighted per share value of roughly $7.50.  If they manage to hit their target the value would be $15.  Obviously it would take them awhile to get to that point, so the value would have to be discounted.  But it does imply that the $7 per share “takeout” valuation isn’t ludicrous.

 

Combining the Diamond ($18) and Emerald valuations ($7), I get a valuation of $25, or roughly 67% upside to the current price.

 

-- Quality of the Business / Return on Invested Capital

 

Given the lack of segment data, I have evaluated the quality of the Diamond business, fully burdened for all investment.  The business is very seasonal, with approximately 60-65% of sales occurring in the first two quarters (ended October and January).  There is also a surge in inventory as the walnut crop rolls in (partially offset by a payable to the growers).  I averaged working capital over the last four quarters ($83mm), and I added to that the ending net PP&E ($29mm) for a total capital investment of $112mm.  Using Diamond’s projected EBIT for 2007 (with 16% gross margin) I get pre-tax ROIC of 27%.  Importantly the PP&E figure represents a good bit of excess capacity, as management sees itself set to handle multiples of Emerald’s current sales level without major capacity additions following its acquisition of Harmony.  The 27% is therefore undoubtedly low, as there is clearly some investment associated with Emerald.  Hence the market multiple of 15x earnings that I advocate seems reasonable.

 

Apologies for the length, but I’ll add a few more thoughts in Q&A.

Catalyst

The catalyst for value realization will likely be continued growth in the Snack business and gross margin improvement. I believe that the obfuscation of the value stems primarily from the losses being generated by the Snack business. Growth will come from new SKUs, its new doors (Target, Publix, etc.) and potential wins at Wal-Mart and the club channel. It is unlikely that DMND will begin to break the two businesses out in their financials for competitive reasons. While a buyout of the company at this level makes eminent sense, I do think it is more of a long shot.