Has Diamond Foods Lost Its Luster?

The journey from sleepy cooperative to snack powerhouse is stopped by an accounting probe

Diamond Foods’ Chief Executive Officer Michael J. Mendes has used a combination of product innovation, savvy marketing, and acquisitions to transform a sleepy cooperative for walnut growers into a $1 billion-a-year purveyor of such snacks as Kettle chips and Pop Secret popcorn. Diamond’s pending $2.35 billion deal for Procter & Gamble’s Pringles brand was to be Mendes’s crowning achievement, a move that would double annual sales to $2.4 billion and extend Diamond’s reach into Asian and Latin American markets.

Except only weeks before the deal was set to close, Diamond’s board announced in November that its audit committee was investigating whether money paid to walnut growers in September violated accounting rules. The company’s treatment of the payment may have helped buoy Diamond’s share price—making the Pringles purchase easier to accomplish. The accounting, now also the subject of a probe by the U.S. Securities and Exchange Commission and class action litigation, may scuttle the Pringles deal if it leads to an earnings restatement of two or more years, according to Jefferies analyst Thilo Wrede. More than half of Diamond’s market value has been wiped out since questions about the payments emerged, casting a harsh spotlight on Mendes, who declined through a spokesman to comment on the company’s accounting issues. “This company was on the verge of becoming a real global consumer-product company with Pringles,” says RBC Capital Markets analyst Edward Aaron. “I always said if they could make it work, it could be a highflier. And it worked—until it didn’t.”

At issue are so-called momentum payments Diamond sent to walnut growers on Sept. 2. Diamond in early October said the money was a prepayment for the current crop year and should be counted as an expense in its 2012 fiscal year that began in August. Short-sellers claim the payments were made to top off growers who were underpaid in fiscal 2011 and should be applied to that year instead, according to Louis Meyer, a special situations analyst at Oscar Gruss & Son.

Growers such as Sally Kafkares, who farms 40 acres in Rio Oso, Calif., say they were underpaid for last year’s crop to the tune of 40¢ a pound. The September payment should be for last year, she says. (Diamond says its pacts with growers are confidential.) “If these costs were improperly allocated, Diamond’s expenses were higher in the prior year and thus its earnings are lower,” Meyer says. “The nature of these payments is somewhat nebulous, and the shorts are saying, ‘I don’t know what’s going on here, but it’s not good.’ ” Short interest as a percentage of Diamond’s shares outstanding (a measure of bets by speculators that the stock will fall) is 41 percent, making it the most shorted stock on the Russell 2000 as of Jan. 9, says data provider Data Explorers.

Crediting the payment to Diamond’s 2011 fiscal year results would have lowered its profits. A restatement of those results could put Diamond in breach of a provision in the Pringles agreement to provide an accurate portrayal of its finances, according to the agreement. Booking that expense last year would have cut Diamond’s profit to $1.14 a share from $2.61, according to an analysis by Mark Roberts, president of Off Wall Street Consulting, a researcher whose clients are short-sellers. “We think it is likely there could be a restatement,” he says.

That would make the exchange of Diamond shares for Pringles much less attractive to P&G shareholders, who would own 57 percent of Diamond after receiving stock as payment under terms of the deal. P&G said on Dec. 15 that the Pringles sale depends on the “favorable resolution” of Diamond’s investigation. The companies must settle all issues by June 30, under the buyout terms. Diamond’s board hopes to complete its inquiry by mid-February.

Much is hanging in the balance for Mendes, who majored in agribusiness management at California Polytechnic State University, where he was student body president. After earning his MBA at the University of California at Los Angeles, Mendes joined Diamond in 1991, working in sales and marketing. In 1997 he was tapped to lead the co-op, a collection of growers who band together to process and market products. The co-op was losing members and market share. Mendes threw himself into the job, sometimes visiting factories at 3 a.m. to schmooze with workers loading cases of nuts, says a retired Diamond executive.

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

Mendes also shook up Diamond’s culture. He moved the headquarters from rural Stockton, Calif., the co-op’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 every day—unusual in the food sector—and fostered a demanding, entrepreneurial environment. “He really changed the culture,” says Mike Riley, who joined Diamond in 1987 and rose to chief financial officer 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.”

Those who stayed saw stunning growth. A year into the CEO job, Mendes pledged to boost sales to $500 million from about $200 million in five years. With new products like glazed walnuts and snack mixes, which led retailers such as Safeway and restaurants like McDonald’s to buy more from Diamond, Mendes blew past the goal.

Successes like that enabled him to push for an initial public offering in 2005. But he had to win backing from the co-op’s members, who feared losing control. Mendes did so through nonstop meetings with growers. “There was only one guy who could sell the IPO, and that was Mike,” recalls a former executive.

The offering gave Diamond capital to do the $190 million acquisition of Pop Secret from General Mills in 2008 and the $615 million purchase of Kettle from Lion Capital in 2010. With the ink on the Kettle deal not yet dry, Mendes pursued Pringles, noting “you don’t get to pick your time with good transactions.”

Now, Diamond’s plummeting stock might force it to assume as much as $200 million more in debt on top of the $850 million already baked into the Pringles deal. That’s if the transaction is completed. With the SEC investigating, figures Wrede, “the probability of the Pringles acquisition closing is now even less certain.”


    The bottom line: Diamond Foods used innovation and acquisitions to become a winner, but an accounting probe has hurt share value by 50 percent.

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