Diamond Foods May Contain Nutty Accounting

After nearly a year of keeping investors in the dark, Diamond Foods is set to report 2012 quarterly earnings and restatements to the company's 2010 and 2011 annual earnings in disclosures that will reveal just how deep an accounting scandal hits the popular snacks maker.

Already, findings of poor accounting controls by Diamond Foods's board have led to the departure of senior management and nearly caused the company's shares to be delisted from Nasdaq.

Meanwhile, Diamond Foods' murky finances have prompted a Securities and Exchange Commission review, annulled its acquisition of chip maker Pringles and put the company in a tenuous position with its lenders, which includes a syndicate of banks led by Bank of America and distressed debt specialist Oaktree Capital.

While, shares in the San Francisco-based maker of Emerald Nuts, Pop Secret, and Kettle Chips surged more than 14 percent in Tuesday trading after the company said in a press release it will provide re-stated annual earnings and disclose financial results from first three quarters of 2012, large risks for investors remain.

Notably, Wednesday's earnings and restatements — expected after the bell — will provide a full view of the depths of Diamond Food's accounting issues and will give a clearer picture on how harsh lender agreements will be for the company and its shareholders.

In the restatement, analysts are keying in on how the accounting review will impact Diamond Foods bottom line, and in particular, walnut supply costs. Higher costs related to supplies and grower payments could depress restated annual earnings more than initial comments from the company's board suggest and cut at 2012 profitability, putting Diamond Foods in weak standing with its lenders and imperiling its shareholders.

Meanwhile, the firm's day-to-day management remains up in the air after the Securities and Exchange Commission opened an inquiry into the firm's practices in late 2011 and an internal board review uncovered flaws in reported financial statements that led to the departure of of its CEO and CFO in February.

Clarity on Diamond Food's accounting represents just one in a host of issues for the company.

Already, the Diamond Foods has lost a winning April 2011 bid to buy Pringles, which was pulled from the selling block by former owner Procter & Gamble in the wake of Diamond's accounting issues. In February, Kellogg scooped up Pringles from P&G for $2.7 billion.

Compounding the fallout from Diamond Foods's Pringles play are the debts that the company took out for the acquisition. After arranging for over a billion dollars in bank loans from a syndicate led by Bank of America to make the deal, the company has had to repeatedly negotiate forbearance agreements with its lenders after breaching disclosure and leverage covenants.

In May, Diamond Foods was able to lower its bank debt load by taking a $225 million loan with distressed debt specialist Oaktree Capital. While some initially saw Oaktree as a so-called "white knight," a closer look at the terms of the deal indicates shareholders may face further downside were Diamond Foods earnings to be hit hard by restatements.

Oaktree Capital gave Diamond Foods a $225 million loan at a 12 percent annual interest rate that expires in 2020 and can be paid-in-kind during its first two years. Oaktree may also get warrants to buy roughly 4.4 million Diamond Foods shares, or 16.4 percent of the company's outstanding shares, at a price of $10 a share — roughly half the company's share price as of Tuesday's close.

With the apparent risk of delisting out of the way, even after Diamond Foods missed a series of Nasdaq earnings guidelines and cancelled its July 31 annual shareholder meeting, Jefferies analyst Thilo Wrede — one of the few analysts maintaining coverage on Diamond Foods — details eight things to watch for in the earnings data dump expected after the market close on Wednesday.

Of most concern will be whether restatements will be in line with initial disclosures made by Diamond Foods's board in February, or if the company's accounting issues will escalate. Were restatements to be greater than commentary suggests it could open up a series of questions for investors.

According to Wrede of Jefferies, the most pressing question for the company is whether restatements are limited to Diamond Foods grower payments. Already, Diamond Foods has indicated it will have to increase its 2011 costs of goods sold by $40 million and 2010 figures by $20 million. "If there are more restatements than just those reflecting the grower payments, what are they and what caused them?" wrote Wrede, in a Tuesday note sent to clients.

Diamond Foods should also have a detailed explanation of the root cause of its accounting issues, according to Wrede.

"[Diamond Foods] has limited its explanation of the cause of the restatements to a breakdown of internal controls. We are looking for a more complete explanation of what went wrong and what steps have been put into place to ensure such a breakdown does not recur," Wrede added.

Wrede also wants to see disclosure on when Diamond Foods will report fourth quarter 2012 earnings and those for the first quarter of 2013, with his understanding that the company has to file results by mid-December.

Given Diamond Foods complicated recapitalization agreement with Oaktree Capital, Wrede notes it's still uncertain whether the company will be able to cancel stock warrants at $10 a share due to Oaktree, and convert $75 million in debt to preferred stock carrying a 10-percent dividend. To not dilute shareholders by way of a warrant exercise at depressed price, Diamond will need to secure $125 million pounds of walnuts by year-end within a gross profit target of $54.4 million and a 14.9-percent gross margin.

Three other issues Wrede highlights are clarity on the company's future cost structure in its walnut and snacks businesses, detail on the strength of its balance sheet given the prospect of shareholder lawsuits, and an outlook on how to grow the business now that Pringles has fallen into the hands of a competitor and suppliers are demanding higher costs.

The company also needs to appoint a permanent CFO and give investors a sense of whether it will replace restructuring specialists who have taken the reins of the company with permanent executives, according to Wrede.

Previous to Oaktree's investment, Diamond Foods' lenders agreed to a forbearance on its debt after the company suspended its dividend and began to work with financial advisor Dean Bradley Osborne to raise capital and maintain covenants.

In May, Diamond Foods hired Brian Driscoll, a former Hostess Brands and Kraft Foods executive as its new CEO.

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.

—By TheStreet.com's Antoine Gara

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