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Diamond Foods Valuation Under Pressure

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After nearly a year of keeping investors in the dark, Diamond Foods (NASDAQ:DMND) reported 2012 quarterly earnings and restatements to the company's 2010 and 2011 annual earnings, which helped to put accounting issues behind the snack maker, but raised new questions about the company's valuation and growth outlook.

In a set of earnings released after the market close, Diamond Foods, the maker of Emerald Nuts, Pop Secret, and Kettle Chips snacks, said that restatements to previous years' earnings were less than a February audit committee review of the firm's accounting practices indicated.

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While senior management stressed that the long overdue earnings put to rest many of the accounting issues lingering over the firm, the company's 2012 earnings came well short of expectations and raised the prospect that a late May recapitalization by distressed debt fund Oaktree Capital (NYSE:OAK) will dilute shareholders.

For the first three quarters of 2012, Diamond Foods reported a net loss of $53.4 million or $2.46 per share, as new arrangements with the company's walnut suppliers and overhead costs cut at the company's bottom line.

Because walnut supply costs ran higher than optimistic terms laid out in Oaktree Capital's $225 million late May loan, Diamond Foods was unable to acquire the walnut volumes to trigger a redemption of $10 warrants in the company's stock that represent 16.4% of its outstanding shares, and may cause common investors to be diluted at discount prices.

Meanwhile, Diamond Foods' higher costs imply a new growth profile for the San Francisco-based company, and an initial outlook provided by management of up to $980 million in full-year 2012 revenue and $81 million in earnings before interest, taxes depreciation, and amortization project near 30% year-over-year declines.

The mix of a leaner profitability outlook and the prospect that Oaktree Capital will be able to convert its warrants at discount prices sent Diamond Foods shares to new lows since its accountancy issues came to a head in February.

In early Thursday trading, Diamond Foods shares were off over 22% to $15.20, a new five-year low in the company's stock.

On the positive side, Diamond Foods management stressed on a conference call with investors that restatements and 2012 earnings remove a cloud of uncertainty and will help the company focus on the future and growing its popular up-market snacks brands once more.

Meanwhile, Diamond Foods also has a "runway" to turn its earnings around after the company reached a forbearance agreement with a syndicate of bank lenders by Bank of America (NYSE:BAC), which removes restrictive loan covenant and gives management the flexibility to re-position the company.

Already, interim Diamond Foods management laid out a restructuring of the firm's Emerald and Kettle snack brands, which may help the company's long-term earnings.

Thilo Wrede, an analyst with Jefferies, wrote in a note to clients that while Diamond Foods' earnings helped to remove some uncertainty, they also raised the prospect that profits will continue to fall, making valuation a tough exercise.

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"Instead of driving growth through promotions and discounting, gains for both brands are supposed to come more from innovation, equity building measures, and price increases to position them clearly in the premium segment, thereby enhancing the attractiveness for certain consumer segments," writes Wrede, of Diamond Foods' new Emerald and Kettle strategies.

While Wrede says the approach may grow margins over time, it might pressure the company during a transition that will likely last for many quarters.

"While we are still in the process of updating our model and reviewing our outlook for the company, we believe that a reduced growth outlook, even if at least partially offset by a better margin picture, will continue to pressure valuation for the stock -- at least for the time being," wrote Wrede in a note to clients that maintained a 'Hold' rating and a $27 price target.

Before calculating a new valuation, the analyst said Diamond Foods needs to give more visibility on its earnings, supply costs, and profit margin outlook. Wrede did note that after a sharp share price drop, Diamond Foods valuation implies a 12.8x enterprise value to EBITDA multiple -- when counting the dilution of Oaktree's warrants -- which is in line with competitors like Hershey's (NYSE:HSY).

Prior to Wednesday's earnings, Wrede, one of the few analysts maintaining coverage on Diamond Foods, detailed eight things to watch for in the company's earnings data dump.

Of most concern is whether restatements would be in line with initial disclosures made by Diamond Foods' board, which they were. Diamond Foods indicated in February it would have to increase its 2011 costs of goods sold by $40 million and 2010 figures by $20 million. However, restatements of $39.4 million and $17 million were less than initial forecasts.

Diamond Foods should also have a detailed explanation of the root cause of its accounting issues, Wrede noted. In a follow-up, the analyst seemed disappointed on that front. "DMND today did not provide any incremental details on the cause for the restatement but assured investors that the necessary steps were taken to prevent a repeat," Wrede wrote, in a note released on Thursday.

Wrede also highlighted clarity on when Diamond Foods will report fourth quarter 2012 earnings and those for the first quarter of 2013. Management did not provide an update on future earnings and, according to Wrede's understanding, the company has to file results by mid-December.

On the disappointing side, the company was unable to meet walnut volume thresholds to cancel Oaktree's warrants, raising the prospect of shareholder dilution.

Other issues Wrede highlighted were clarity on the company's future cost structure in its walnut and snacks businesses, and detail on the strength of its balance sheet given the prospect of shareholder lawsuits -- concerns left largely unaddressed in earnings.

While Diamond Foods appointed new board members, it did not disclose whether it has found a permanent CFO or give investors a sense of whether it will replace restructuring specialists who have taken the reins of the company with permanent executives.

Diamond Foods' troubles began in February when an audit committee review of its finances found significant accounting inconsistencies for its walnut supplies, forcing the immediate suspension of its CEO Michael Mendes and CFO Steven Neil. The review also cast doubt on the accuracy of two years' worth of earnings statements, and delayed three quarters of earnings filings.

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