Diamond Foods Accounting Probe Threatens Mendes Legacy

Diamond Foods Inc.’s investigation into whether money paid to walnut growers in September violated accounting rules has thrust Chief Executive Officer Michael Mendes into a role he’s unaccustomed to: Playing defense.

Mendes, the 48-year-old son of immigrants who settled in California’s fertile Central Valley, has used a combination of marketing, innovation and acquisitions to transform Diamond from a walnut cooperative into a $1 billion purveyor of such snacks as Kettle chips and Pop Secret popcorn. Diamond’s $2.35 billion deal for Procter & Gamble Co.’s Pringles was to be Mendes’ crowning achievement, doubling sales to $2.4 billion and pushing Diamond into Asia and Latin America.

The investigation, since taken up by the U.S. Securities and Exchange Commission, may scuttle the Pringles deal if it leads to an earnings restatement of two or more years, according to Thilo Wrede, an analyst at Jefferies & Co. in New York. More than half of Diamond’s market value has been wiped away since questions about the payments emerged, which has led analysts such as Wrede to question their faith in Mendes, who declined to comment through a spokesman.

“There are not that many growth stories in the food industry and this one was intriguing,” Edward Aaron, an analyst at RBC Capital Markets, said in an interview. “This company was on the verge of becoming a real global consumer-product company with Pringles. I always said if they could make it work, it could be a high flier. And it worked -- until it didn’t.”

Diamond’s board, along with external legal and audit firms, are looking into so-called “momentum payments” Diamond sent to walnut growers in September. Diamond said the money was a prepayment for the current crop year, and as such should be included in its 2012 fiscal year, which began in August.

Grower Payments

Some growers and short-sellers say the payment was to top off growers who were underpaid last year, according to reports in the Wall Street Journal and Barron’s. If so, the payment belongs in Diamond’s 2011 fiscal year, which would have reduced its annual profit to $1.14 a share from $2.61, according to an analysis by Mark Roberts, president of Off Wall Street Consulting Group Inc., a New York research firm.

That would make the exchange of Diamond shares for Pringles much less attractive to P&G shareholders, who will own 57 percent of Diamond under terms of the deal. P&G said Dec. 15 that the Pringles sale depends on the “favorable resolution” of Diamond’s investigation. Diamond told the Journal its agreements with growers are confidential.

Diamond rose 2.2 percent to $32.91 at 12:31 p.m. in New York. The shares slumped 39 percent last year.

Walnuts Probe

While walnuts are the focus of the probe, they’re no longer center stage at Diamond thanks to Mendes, whose parents came to the U.S. from the North Atlantic’s Azores islands speaking no English. Mendes was attracted to agriculture early on and majored in agribusiness management at California Polytechnic State University in San Luis Obispo, where he was student body president.

Soon after earning his MBA at UCLA, Mendes joined Diamond in 1991, working in sales and marketing. In 1997, Diamond’s board chose Mendes to lead the cooperative, a collection of growers who band together to process and market their products. At the time, it was losing members and market share.

Ambitious and hard-working, Mendes threw himself into the job, sometimes walking into factories at 3 a.m. to schmooze with workers loading cases of walnuts, according to a former Diamond Foods executive who has since retired. Mendes’s communication skills were so admired, he was compared to President Ronald Reagan, known as “The Great Communicator,” the former executive said.

Sleek Canisters

At the time, walnuts were mainly used by housewives for baking brownies and other sweets. Mendes saw an opportunity to boost sales by marketing walnuts to younger consumers as a snack, while also expanding into other nuts like almonds and cashews. He created a new nut brand, Emerald, backed by TV ads - - including Super Bowl spots -- and sold in sleek green canisters that fit into car cup holders. And Diamond pushed walnuts as nutritious, chock full of heart-healthy Omega 3 fatty acids.

“The essence of the Diamond growth story is the development of the Emerald snack nut brand,” Mitchell Pinheiro, an analyst at Janney Montgomery Scott LLC in Philadelphia, said in a 2009 report entitled “Diamond is an Investor’s Best Friend.”

Diamond’s Culture

Mendes also shook up Diamond’s culture, said two former executives. He moved the headquarters from rural Stockton, the cooperative’s home since 1912, to San Francisco, where he could attract more talented employees, including those from outside the food industry. He encouraged employees to wear ties everyday -- unusual in the laid-back food industry -- and fostered a demanding, entrepreneurial environment not unlike the technology startups headquartered nearby. Mendes even got superstar athletes, like San Francisco 49er legend Ronnie Lott, to pop by for motivational talks.

“He really changed the culture,” said Mike Riley, who joined Diamond in 1987 and rose to CFO before retiring in 2004. “He had a big vision and confidence that we were going to be the best. But if you did not perform, you would not last long.”

A year or so into the CEO job, Mendes pledged to grow sales to $500 million from about $200 million in five years. With new products like tasty glazed walnuts and snack mixes, which encouraged retailers like Safeway Inc. and restaurants like McDonald’s Corp. to buy more of Diamond’s nuts, Mendes blew past the target.

Kettle Deal

Successes like that enabled Mendes to secure backing from the cooperative’s walnut growers to push for an initial public offering in 2005. That gave Diamond capital to pursue the $190 million Pop Secret acquisition in 2008 and the $615 million Kettle deal in 2010. With the ink on the Kettle deal not yet dry, Mendes pursued Pringles, telling analysts who said he’d bitten off more than he could chew that “you don’t get to pick your time with good transactions.”

And it was a good deal, according to analysts, at least as proposed. Now, Diamond’s plummeting stock might force it to assume as much as $200 million more debt on top of the $850 million already baked in. And that’s if the deal -- originally slated to close this month -- gets done at all. With the SEC now investigating, “the probability of the Pringles acquisition closing is now even less certain,” according to Wrede, who recommends holding the shares.

The investigation may conclude by the middle of February, Diamond said Dec. 12.

All those issues have kept Mendes on the defensive, huddled with lawyers, accountants, and P.R. specialists instead of where he usually is -- out on the road, selling his snacks and his company. Now, he has to answer for Diamond’s explosive growth and pull back the curtain on its often-obscure dealings with growers, said Aaron, who is based in Denver and rates the shares “sector perform.”

As the company’s CFO said during an earnings call in March, “If there was one easy answer, it wouldn’t be Diamond Foods, right?”

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