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Diamond Foods (NasdaqGS: DMND) is a Fraud

By Jim Fink on February 10, 2012

Diamond Foods (NasdaqGS: DMND), the snack food company whose three main brands are Emerald Nuts, Pop-Secret popcorn, and Kettle potato chips, collapsed 37% on Thursday (Feb. 9th ) on news that its board’s audit committee had concluded that former CEO Michael Mendes and CFO Steven Neil had engaged in accounting fraud. Specifically, $60 million in payments to walnut growers had been improperly shifted from the fourth quarter of fiscal 2011 (ended July 2011) into the first quarter of fiscal 2012.

The motivation for the fraudulent cost shifting was to make full-year 2011 earnings per share look much better — $2.61 rather than $1.14. The company needed higher earnings in order not to breach a “debt-to-earnings” covenant in one of its debt agreements. The fraudsters probably also hoped that the inflated earnings would entice Procter & Gamble (NYSE: PG) to quickly close the April 2011 agreement to sell its Pringles brand of potato chips to Diamond. Even with fraudulent numbers, the Pringles sale was expected to “modestly” dilute P&G earnings by $0.02 to $0.04 on an annualized basis and Diamond’s former executives didn’t want the dilution to look even worse.

Shifting current expenses to a later period in order to make current earnings look higher is “Shenanigan No. 4” in forensic accountant Howard Schilit’s classic book on accounting fraud entitled Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports.

Procter & Gamble Unofficially Walks Away from Its Pringles Deal With Diamond Foods

As I wrote this past December in Selling Pringles to Diamond Foods is Nuts, P&G curiously remained committed to the all-stock deal even after learning of the accounting fraud allegations and the suicide of a Diamond Food director who had been in charge of Diamond’s audit committee. On December 15th, a couple of weeks after my article was published, P&G made clear that the consummation of the Pringles transaction would only occur if Diamond’s internal accounting investigation and an accompanying SEC probe ended with a “favorable resolution.”  The February 8th news of fraud obviously did not constitute a favorable resolution, but P&G issued the following statement on its corporate blog that maddeningly failed to definitively cancel the deal with Diamond:

The information released by Diamond Foods is very disappointing. Pringles remains a valuable asset and it has attracted considerable interest from other outside parties. 

We need to evaluate next steps and we are currently keeping all our options open. As we evaluate the right next steps, we will be guided by what is best for our shareholders and our employees.

Bloomberg News reports, however, that P&G has decided to nix the Pringles transaction, which is good news for P&G shareholders. At Diamond Foods’ current stock price of $24, the value of the 29.1 million shares of Diamond Foods stock and assumption of $1.05 billion in Pringles’ debt that would be used to purchase Pringles amounts to only $1.75 billion. Pringles, the fourth-largest snack brand in the world with $1.4 billion in annual sales, is worth more than $1.75 billion. Of course, Diamond Foods stock could fall further if the accounting fraud results in shareholder class action litigation, criminal fines, breakup fees, debt covenant penalties, etc., so even the $1.75 billion figure could be a mirage. Bottom line: the last thing that P&G shareholders need is a low-ball price based on tainted stock from a fraudulent company in exchange for a valuable business like Pringles.

As of Friday Feb. 10th at 1:10 PM, however, the Diamond Foods website still prominently lists the April 2011 Pringles merger announcement as its top piece of “news.” Hope springs eternal at Diamond that P&G won’t back out, but it’s pretty darn pathetic.

Diamond Foods May Have to Pay a $60 Million Break-Up Fee

The question remains whether Diamond has any legal grounds to demand a breakup fee from P&G. I seriously doubt Diamond is entitled to anything given the accounting fraud. In fact, Diamond may be required to pay P&G a $60 million breakup fee since it represented to P&G in the Pringles contract documents that its financial statements were accurate. Furthermore, the Pringles contract expressly allows P&G to back out of the transaction if Diamond’s business suffers a “material adverse change” prior to closing. I think we can all agree that accounting fraud and the dismissal of the CEO and CFO constitute such a material adverse change?

David Einhorn Didn’t Buy Diamond Foods as a Long Position

Back in December, I was shocked to read a rumor that hedge-fund manager David Einhorn had invested in Diamond Foods. Why would a well-respected investor – one whose Greenlight Capital hedge fund has outperformed the S&P 500 for 13 consecutive years – risk his limited partners’ money  and his reputation on a company accused of cooking its books? It simply made no sense. As with most rumors, it turned out to be false although it contained a kernel of truth. In fact, on January 17th Einhorn disclosed in his fourth-quarter shareholder letter that he had recently bought Diamond stock, but it was to close a short position, not to open a long position. Mystery solved, although I am certain that Einhorn is kicking himself for closing the Diamond short before this week’s stock plunge.

Avoid the Temptation to Bargain Hunt in Diamond Foods

With Diamond Foods stock trading at $24, 75% below its 52-week high of $96 reached last September 21st, some bargain hunters will inevitably buy the stock on the hopes for a rebound. After all, the accounting fraud apparently involved only the time-shifting of expenses, not the fabrication of revenues. The revenue-generating power of Diamond’s snack brands has — so far — not been challenged.

One analyst thinks the stock is still worth – even taking the accounting fraud into account — up to $44 per share based on the breakup value of its current assets. Another analyst sees Diamond’s post-fraud earnings power for fiscal 2012 at $1.70 per share, which equals a very-reasonable 14 times earnings based on the stock’s current $24 share price.

My take: all of these analyst estimates are pure speculation and meaningless given the huge uncertainties surrounding Diamond Foods right now. The only prudent thing to do is avoid the stock and focus on less controversial investment opportunities like P&G itself!

Two other long ideas from page 4 of David Einhorn’s fourth-quarter shareholder letter are:

(1) computer assembler Dell (NasdaqGS: DELL), established at an average price of $15.53 (now trading at $17.81); and

(2) document management company Xerox (NYSE: XRX), established at an average price of $7.61 (now trading at $7.91).  

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  1. avatar
    David Schwartz Reply February 19, 2012 at 1:20 AM EST

    In his latest quarterly disclosure, Bill Gates shows that he bought three hundred and fifty thousand shares of Diamond Foods. His average cost was $47.59 a share. He bought some shares of Diamond Foods when the stock was trading north of $77! He averaged down by buying more shares of Diamond Foods at $26 and change. Let us see what Bill Gates does with his shares of DMND. Maybe he will buy more shares of DMND, so that his overall cost basis will be much lower than $47.59 a share.

  2. avatar
    Diane Reply February 12, 2012 at 1:06 AM EST

    shoot! dmnd has been a little diamond in the rough for me for a few yrs now. I don’t check stocks every day, but this was a shock. what to do, what to do.

  3. avatar
    Stan Reply February 11, 2012 at 5:06 PM EST

    correction of site for article,….a- cute-t-shirt

  4. avatar
    Stan Reply February 11, 2012 at 4:56 PM EST

    Hi Jim, I don’t think you would have such a high opinion of David Einhorn after reading the following article,
    His career stats as an investor have been greatly enhanced by his practice of shorting stocks, spreading nasty false rumors about the company through his network of hedge fund cronies and media people, and covering his shorts when the stock dives. He was recently fined eleven million in Britain for trading on insider information.

  5. avatar
    JoeNatural Reply February 10, 2012 at 10:10 PM EST

    The panic drop has created a “buy when there’s blood in the street” scenario. Short-sellers will of course paint a “gloom and doom” picture, but for Heaven’s sake, the only difference between today and Wednesday is that we all now have confirmed what was already known for months. So there’s two payments that were recorded incorrectly ….. big deal. The net effect will be zilch and while challenges await, the bad apples are gone and the interim CEO used to be the head hancho (CEO) at Del Monte. Management has what it takes to turn this ship around. Good grief, let’s give the company some credit, as they grew revenues by 42% in 2011 YOY. Pringles? Who cares if the deal falls through.

  6. avatar
    John Neubauer Reply February 10, 2012 at 6:45 PM EST

    This is similar in many ways to the Rite Aid “accounting” problems of several years ago. I am glad that in the US we have regulations requiring outside auditors for publically traded companies. Even outside auditors don’t always get it right [Enron….]