Wednesday, 7 October 2015

Diamond Foods circa 2012, and First Level Thinking

I love chips.  If presented with a choice between Kettle Brand or Ms. Vickies, I don't even know if I'd be able to choose between the two.

Prior to 2012, Diamond Foods was a growth story.  Hot off the Kettle Brand acquisition in 2010, Diamond negotiated a deal to buy Pringles from Procter & Gamble in April 2011.

From the WSJ in April 2011:

Procter & Gamble Co. agreed to sell its Pringles line of snacks to Diamond Foods Inc. for $1.5 billion, under a deal designed to minimize the tax bite while fully cleaning its cupboards of food brands.  The transaction, in which P&G shareholders will get Diamond Foods stock and Diamond will assume $850 million of Pringles debt, marks P&G's exit from the food business. The process began under former Chief ExecutiveA.G. Lafley, who shifted the portfolio toward faster-growing, higher-margin goods, namely beauty and personal-care products.

Here's what Cramer had to say shortly after the deal on Mad Money:

Cramer's Mad Money - I'm a Believer in Diamond Foods (5/26/11)

Stocks discussed on the in-depth session of Jim Cramer's Mad Money TV Program, Thursday May 26.

CEO Interview: Michael Mendes, Diamond Foods (NASDAQ:DMND). Other stocks mentioned: Procter & Gamble (NYSE:PG)

Diamond Foods (DMND) is one of the "best and brightest snack food companies on Earth" and hit a 52 week high on the success of its brands such as Pop Secret and Kettle Chips. The company is buying Pringles from Procter & Gamble (PG) for $2.5 billion, and Cramer thinks the acquisition will make Diamond a "global snacking powerhouse." The stock has seen a 70% gain since Cramer got behind it in October 2010 and is up 47% since last December.

Cramer asked CEO Michael Mendes how Diamond will succeed with Pringles where Procter & Gamble didn't. Mendes pointed out that 60% of Pringles sales are outside of the U.S, and demand for the snack is growing. Pringles also has a whole wheat version of the favorite snack that will appeal to health-conscious consumers. When asked about competition, Mendes replied there are "unlimited opportunities" in the global snack universe. He added that the company has substantial experience dealing with fluctuations in commodity costs. The company continues to transform brands it purchases and has seen success with its 100 calorie portion-controlled items.

"The stock has had a big move," Cramer said. "You do the homework. I'm a believer in Diamond Foods."

Here's the chart pre 2012 (can you smell the Cramer?):

I remember the events leading up to and during 2012 pretty vividly. 

Everything came unravelled right after the Pringles deal was announced.  Diamond was going to take on a ton of debt (and issue additional shares) in order to make the Pringles deal work. Here's a description of the deal in more detail from Dealbook:

"Diamond Food was leveraging up to buy Pringles, assuming $850 million in debt. This was also a deal in which a minnow would be swallowing a whale. At the time the deal was announced, 2011 revenue at Pringles was estimated to be about $1.4 billion. Diamond’s 2011 estimated revenue was a third lower, at about $950 million.

Because Diamond could not afford to pay cash for Pringles, Diamond intended to issue $1.5 billion in its common stock in connection with the transaction. Because Pringles was so much bigger, Diamond shareholders would have only owned 43 percent of the combined company. P.&G. shareholders would have owned the rest, a majority of Diamond’s shares."

To make matters worse, Diamond became embroiled in an accounting restatement scandal.  My layperson's guess is, that in order to pitch the Pringles deal, Diamond fudged the #'s as they would need P&G to take an ownership stake in the transformed company.

Here's the SEC release on the accounting fraud settlement (issued Jan 9, 2014):



Washington D.C., Jan. 9, 2014 — The Securities and Exchange Commission today charged San Francisco-based snack foods company Diamond Foods and its former CFO in an accounting scheme to falsify walnut costs in order to boost earnings and meet estimates by stock analysts.  The SEC also charged Diamond’s former CEO for his role in the company’s false financial statements filed with the SEC.

The SEC alleges that Diamond’s then-chief financial officer Steven Neil directed the effort to fraudulently underreport money paid to walnut growers by delaying the recording of payments into later fiscal periods.  In internal e-mails, Neil referred to these commodity costs as a “lever” to manage earnings in Diamond’s financial statements.  By manipulating walnut costs, Diamond correspondingly reported higher net income and inflated earnings to exceed analysts’ estimates for fiscal quarters in 2010 and 2011.  After Diamond restated its financial results in November 2012 to reflect the true costs of acquiring walnuts, the company’s stock price slid to just $17 per share from a high of $90 per share in 2011.

Diamond Foods agreed to pay $5 million to settle the SEC’s charges.  Former CEO Michael Mendes, who should have known that Diamond’s reported walnut cost was incorrect at the time he certified the company’s financial statements, also agreed to settle charges against him.  The SEC’s litigation continues against Neil.

Here's the chart post 2012 (Cramer long gone):

Failed Pringles acquisition, ongoing delays in restated financials, severe deficiencies in controls, dividend cut, stock price falls from $90 to $13, SEC investigation, Oaktree capital emergency loan, this was a toxic waste story.

Anyone who based their capital allocation decision on Cramer land was long gone by fall/winter 2012 when they finally reissued their restated financials.  I bet any participants overweight $90 were long gone licking their wounds.

And then something interesting happened in the winter of 2012 after the restatement.  Here's the chart:


So what happened?  Well, here's my theory.

Amidst the business of dealing with controversy, the board fired the CEO and overhauled the systems and controls, got on with the business of getting the restated financials issued, and charged new management with getting back to the business of selling nuts and chips.

I started analyzing the July 31, 2012 10K today (a read through the risk disclosures drawing attention to the accounting scandal, litigation, leverage, investigations etc. in the report would be enough to send a sane investor running for the hills).  Here's an excerpt from the Income Statement:

I made a few simplifying assumptions regarding 2012:

  1. SG&A was unusually high in 2012 vs. 2011. For a company embroiled in the midst of a scandal, I wondered whether the $33.1M increase was directly related to righting the ship.  Indeed, in the 10K, management spoke to having to incur higher SG&A "as a result of the Audit Committee investigation and related lawsuits of $17.4 million, retention and severance plans of $2.6 million, and consulting services of $9.6 million."
  2. $41M of aquisition and related expenses due to the failed Pringles deal were non-recurring in nature.
  3. $10M loss on warrant liability was a non-cash charge related to warrants issued Oaktree.
  4. $10M asset impairment charge was non-cash
Total of the above, assuming the company never sold another nut or potato chip, was around $94M.

I then looked at the cash flow statement (my new favourite friend):

Non cash charges included:

  • Deferred tax of $8.6M
  • Debt issuance costs of $6.4M
  • Payment in kind interest on debt of $3.1M
  • Additional non-cash acquisition cost write offs of $6.4M

Total of the non cash charges plus the non-recurring costs, assuming the company never sold another nut or potato chip, was around $94M + 24.5M = $118.5M.

(I'm going to ignore depreciation because even though it's non cash, it should net against ongoing capx and wash, in theory)

I then ran $118.5M in estimated free cash flow (before any sales of nuts or chips) through my DCF FCF matrix, and here's what I got at G = 0,0, Re = 12% to 15%

2-Stage DCF
Free Cash Flow118.50
Net Debt600
IV per share-22.20
IV per share
Sum of DFC'sRe =
G = 8%9%10%12%15%Average, growth, blended Re
Average, Re, blended growth74.6152.4643.0729.6416.94

Totally nuts (bad pun, I know).

So, here was toxic waste, that no ordinarily sane investor would touch with a 10 foot pole, selling at a theoretical discount to G = 0,0, Re = 12% of  (1 - $13 / $17.86) = 27%.  At Re = 15%, no theoretical discount, but note that Oaktree had debt with a coupon of 12%, so maybe 12% was a sufficient Re.

In any case, and in retrospect, I think this is the type of situation that deep value investors like Seth Klarman might look for.  When overall participant perception of distress is severe, uncertainty is rampant, valuation is inherently complex, and there is a probability of improvement in theoretical free cash flows due either to non-cash or non-recurring cash flows at the highest possible discount rates and lowest possible growth rates, maybe, just maybe, there's a margin of safety.  And the faster the business returns to the business of what it did before the scandal erupted, the faster the gap between depressed valuation and fair valuation closes.

I recall a quote from legendary "Big Short" investor Mike Burry:

Burry’s investment philosophy is to look for what he terms as “ick factor.” This is an investment in companies suffering from serious problems, but which are still, essentially, good investments.

"My strategy isn't very complex. I try to buy shares of unpopular companies when they look like road kill, and sell them when they've been polished up a bit. Management of my portfolio as a whole is just as important to me as stock picking, and if I can do both well, I know I'll be successful."

First Level Thinking and Conclusion

So how did I play this at the time?  I bought January 2013 and $10 and $5 puts and lost money. As a first level thinker, I extrapolated the past developments into an uneducated hypothesis that the company would go bankrupt.  At the time, I had no idea who Klarman, Marks or Burry were.

In conclusion, I want to be able to refocus my thinking from here on in.  I want to be able to elevate my thinking beyond First Level Thinking along the lines of folks like Klarman, Marks or Burry, and I don't know when (or if) I'm going to ever get there.  But I'm going to keep trying. 

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