Diamond Foods Analysis
Board: Value Hounds
DMND has been a falling knife. The stock traded north of $90 per share in September, 2011 and it has fallen to a mere $23.52 per share as I write this. My expectation is that after a 75% haircut in the price per share there would be a high probability that Mr. Market may have created a bargain. I’ve attempted to find out, as best as I can, and I share the highlights of what I’ve learned in the following – my primary objective being to assign a fair value to the shares that I’m reasonably confident in.
The reason for the sell off has been some confessed financial reporting shenanigans concerning the timing of certain expenses. It appears that the now ousted CEO and CFO cooked the books so as to goose reported earnings:
The admitted sin: The Audit Committee has concluded that a "continuity" payment made to growers in August 2010 of approximately $20 million and a "momentum" payment made to growers in September 2011 of approximately $60 million were not accounted for in the correct periods, and the Audit Committee identified material weaknesses in the Company's internal control over financial reporting.
In what follows I’ve assumed that the audit committee’s work has been thorough and complete and that there are no other skeletons in the closet – an assumption that may prove incorrect. The offending CEO and CFO have been ousted, rightly so, and I’m at least willing to entertain the idea that the company can work their way through the consequences of this unfortunate and stupid act by former management. I am impressed by how quickly the board acted in removing a CEO who had long held that post. An SEC investigation of the incident, fines and shareholder lawsuits can be expected.
It should be noted that short sellers have sold about 50% of the float short as of January, 2011. So, there’s a lot of money betting that an even lower stock price lies ahead. Given the improprieties and uncertainty surrounding the shares their pessimism is probably warranted. Another shoe may drop.
I attempted to use one of Professor Damodaran’s spreadsheets to value the shares after making certain adjustments to the financial statements. The adjustments included correcting for the improper timing of expenses and also stripped out one-time acquisition expenditures to arrive at a financial picture indicative of the consolidated business as it currently stands and will likely be going forward. The end result is that I calculated a range of fair values for the stock, depending on various assumptions, of between $19 and $35 per share and, as is often the case, obtained absolutely no confidence in these numbers due to their sensitivity to minor changes in the inputs.
To gain more confidence in my assigned value to the shares and to also narrow the range of values to something more useful, I elected to follow an appraisal approach comparing key valuation metrics of DMND with a few of its peers in the Processed & Packaged Goods industry. The key metrics I chose to concentrate on are:
* Enterprise Value / Revenue
* Net Profit Margin
* Debt / Equity
* Historical revenue growth rate
Because the profitability of DMND is in some doubt due to the expense reporting shenanigans, I believe it reasonable and prudent to view their profit margins with some skepticism and that is why I chose the EV/Revenue metric. DMND has a large amount of debt and I believe that can play a role in determining the fair value for the equity. Growth is of course an important determinant to assigning a fair value multiple.
According to Prof Dam’s website, the average EV/Revenue for the food industry is 1.08x. In general, higher multiples are given to businesses with better than average profitability and/or growth rates.
Some DMND history is important to the appraisal process. Originally founded by a group of walnut growers, DMND primarily supplied walnuts and other nut products to grocery stores as a cooking ingredient. They later launched the Emerald brand of nut snack treats.
In September 2008 they acquired the Pop Secret popcorn brand from General Mills for $190 million in cash (funded by debt) and the brand was expected to add $85 to $90 million in sales in the coming year. They paid 2.11x revenue for this brand which commands a 25% share of the microwave popcorn market.
In the few years prior to this acquisition, DMND showed meager profitability capable of producing net margins of only 1.5%. Revenue growth rates struggled below 3% per year.
After the Pop Secret acquisition, the net margin of the consolidated company improved to around 4%. And, reported growth rates were much higher due to that acquisition – for a year anyway.
In March 2010 DMND acquired Kettle Foods (chips) from Lion Capital for $615 million in cash (funded by debt). At the time of the acquisition, Kettle was expected to add $250 million in revenue and double the company’s EBITDA. They paid 2.45x sales for the Kettle brand and net margins improved to in excess of 5.5% although the expense “shifting” by management played a role in this margin improvement.
Fwiw, I think these two acquisitions were good ones. They allowed DMND to gain shelf space in the grocery “snack” aisle and leverage its legacy nut business by moving more so into that higher margin aisle compared with the lower margin cooking aisle. The reported results seem to suggest that they were successful in doing this.
In April, 2011 DMND announced that they were acquiring the Pringles potato chip brand from P&G in an all-stock transaction valued at $2.35 billion. The Pringles brand has world wide sales of $2.4 billion and its acquisition would vault DMND into the number two snack food company behind only Pepsi’s Frito Lay. Unfortunately, a consequence of the former CEO’s book-cooking shenanigans is that P&G will most likely walk away from this deal due to a material change in DMND’s finances as a result of those shenanigans. For my purposes this deal does provide two key pieces of information: another valuation point, Pringles could be had for about 1.0x sales; and the all-stock nature of the deal may suggest that DMND stock was overvalued at that time. In April, 2011 DMND shares were trading hands at about $60 per share. At that $60 price, DMND’s EV to revenue multiple was about 1.9x. At the $90 per share high price, DMND’s EV to revenue multiple was about 2.6x.
DMND has $530 million of secured debt and that debt has first claim on virtually all the assets (tangible and intangible) that the company owns. Total assets are $1.3B but goodwill and intangibles account for $0.87B of this total. In a bankruptcy scenario, it appears shareholders would be left with nothing as the net tangible asset value is less than the debt owed.
Having rambled on long enough to lose most readers, I’ll get to the meat. Here are DMND’s metrics along with the supporting data:
[See Post for Tables]
I’ve selected these three companies because they show net margins similar to that of DMND’s. You’ll also note that DMND’s 5-year historical revenue growth of 15% is bracketed by these comparable companies too.
I own FLO shares and they are a well run company that historically has grown by acquisitions just as DMND has done in recent years. FLO’s current debt level is relatively high, for it, having just completed a series of acquisitions and the expectation is that they will pay that debt down over the course of the next few years. I’m also confident in saying that I think FLO is about fairly and fully valued at its current price.
My assessment of DMND’s situation is that their acquisition activity will come to a screeching halt for the foreseeable future because their credit lines are nearly tapped out. Their stock is no longer ample currency on which to do a deal with. So, my expectation is that near term future growth will be limited by what can be achieved from reinvested earnings, alone. Their payout ratio is only about 8% as they pay a tiny dividend amounting to about $3.5 million per year.
If all goes well and there exists still untapped synergies from the recent acquisitions, DMND will do well to grow in the 8.5% to 13.1% range exhibited by FLO and CPO. This would suggest a fair value EV to revenue multiple of 1.0x is about the best that can be hoped for.
Based on this, it is my opinion that $25 per share is fair for DMND.
Another way to look at the fair value is to utilize the acquisition multiples for the Pop Secret and Kettle brands. To do this, I’m going to discount the sales multiple paid by an assumed premium for control of 25%. And, I’ll assign a sub-par fair value multiple of 0.8x for the legacy DMND business given its historic sub-par net margin (1.5%). This leads to the following:With that, my bottom line is that I think the fair value for the shares is in the mid-$20’s. At best, $30 per share.
[See Post for Tables]
I’m left to conclude that DMND stock’s big run up to $90 per share was driven by acquisition growth fueled euphoria by the market (qtr over qtr growth rates were 30%+ but it was nearly all the acquisitions and unsustainable) along with a few momentum buyers piling on to the point of no reason. The chart goes straight up starting with the Pop Secret acquisition and accelerates as time goes by. A bubble destined to pop and it did. Still, it’s hard to believe that the valuation could have gotten so out of whack. Perhaps, my valuation is too conservative and the market will one day soon prove me wrong.