By Daniel U. Alvarez
PEREIRA -- On November 1, 2011, Diamond Foods Inc.’s (NASDAQ: DMND) unexpectedly disclosed serious discrepancies (possible understatement of accounts payable) regarding its 2011 financial statement reports and as a result announced its decision to delay its acquisition of the Pringles snack business from Procter & Gamble Company (P&G) (NYSE: PG). Naturally, the November 1, 2011 confession caused an immediate plunge of Diamond Food’s stock price, but worse, it triggered several lawsuits from furious investors and created rumors about the future viability of the company. The purpose of this study is to determine the facts and critically analyze the cause and effect of Diamonds Food’s allegedly financial statement fraud and attempt to make a prediction about the future of this company.
PEREIRA -- On November 1, 2011, Diamond Foods Inc.’s (NASDAQ: DMND) unexpectedly disclosed serious discrepancies (possible understatement of accounts payable) regarding its 2011 financial statement reports and as a result announced its decision to delay its acquisition of the Pringles snack business from Procter & Gamble Company (P&G) (NYSE: PG). Naturally, the November 1, 2011 confession caused an immediate plunge of Diamond Food’s stock price, but worse, it triggered several lawsuits from furious investors and created rumors about the future viability of the company. The purpose of this study is to determine the facts and critically analyze the cause and effect of Diamonds Food’s allegedly financial statement fraud and attempt to make a prediction about the future of this company.
Introduction
Diamond Foods’ core competency is in its innovative food packaging methods and marketing abilities. The company which brands includes; Kettle Brand Potato Chips, Emerald Premium Snacks, Pop Secret Popcorn, and Diamond Culinary Nuts, was clearly in an expansionary mode prior to its November 1, 2011 financial statement revelations. For example, in his 2010 letter to Diamond stakeholders, the Chairman, President and Chief Executive Officer, Michael J. Mendes, announced that “Diamond Foods had a transformational year in 2010…with strong growth and profitability in the core business…the company acquired and successfully integrated the global operations of Kettle Foods…once again generated record earnings while continuing to invest in brands, innovation, operational infrastructure and people” (p. 1).
Undoubtedly, in the last couple of years, Diamond was on a clear trajectory to significantly expand its market share by acquiring other snack food companies. According to a recent comment published in Barron’s Magazine (2011, November 5), “on April, 2011 Diamond Foods took on an even bigger bite by announcing its plans to acquire the Pringles chips business from P&G in exchange for Diamond stock” (p. 1). Diamond’s growth in the past couple of years is truly impressive. Table 1 shows Diamonds net sales growth by product from 2008 through 2010.
Table 2 shows the remarkable increase of Diamond stock especially from October 2010 to October 2011. At its peak, Diamonds stock traded at $95, more than double what it is trading today. Prior to Diamonds’ November 1, 2011 announcement its key financial performance measures were impressive; for example, its Price/Earnings ratio was $23.3, and its Earnings per Share was at 2.23.
Unfortunately, in its aggressive pursuit to increase its market share by acquiring companies of similar product, Diamond may have also created the conditions conducive to fraud, as illustrated in the Fraud Triangle. According to the Public Company Accounting Oversight Board (PCAOB), the “three key components that make up the Fraud Triangle are; perceived pressure, perceived opportunity and rationalization”.
Diamonds’ Leadership
The cliché that “leaders are responsible for everything that happens or fails to happen in an organization” certainly applies to the Diamond Food story. The two most influential individuals within the Diamond Foods’ leadership structure are Michael J. Mendes, Chairman, President and Chief Executive Officer; and Steven M. Neil, Executive Vice President, Chief Financial and Administrative Officer.
Michael J. Mendes, President and CEO
Mendez joined Diamond in 1991. He holds an M.B.A. degree from the Anderson School of Management at the University of California, Los Angeles. Mendez assumed the duties and responsibilities of President and CEO for Diamond in 1997. The immediate impression is that Mendez has an incredible amount of knowledge and experience with the Diamonds’ financial and operational requirements.
Steven M. Neil, Executive Vice President, CFAO
Neil joined Diamond in 2008. Prior to joining Diamond, he served in various companies in financial and information systems capacities. Neil holds an M.B.A. degree from UCLA, a bachelor’s degree in mathematics from UCSB and is a Certified Public Accountant in the state of California. Neil appears to have a lot less knowledge and experience regarding the intricacies of Diamonds operations, but has significant knowledge and experience with financial statement operations and reporting.
The Nut of the Problem
Before Diamonds’ initial public offering in 2005, it core business product for years was packaging and marketing various type of nuts, particularly walnuts. The relationship between Diamond and its walnut farmer suppliers is apparently long and tenuous. For example, according to Alpert (2011, November 5) “the Wall Street Journal talked to some walnut growers and found serious issues with Diamond’s accounting”. Interestingly, prior to Diamonds’ announcement to acquire the Pringles chips division from P&G on April 2011, numerous financial institutions such as Bank of America Merrill Lynch, Morgan Stanley and the Blackstone Group scrutinized the Pringle chips deal and didn’t find any irregularities with the financial proposal. However, the conditions were about to change for Diamond.
Apparently it was the Internal Audit Department at Diamond that first identified the accounting issue after it was pressured by the press regarding the accounting concerns addressed by the walnut farmers. According to Alpert (2011, November 5), Diamonds’ payments to walnut farmers for their fall 2010 crop “came short of market prices”. The controversy lies with a payment made to farmers on September 2011, well after the end of Diamond’s fiscal year closing, July 31, 2011. Diamond classified this particular payment to walnut farmers as “a momentum payment” of 30 to 40 cents per pound for the coming 2011 crop. However, the walnut farmers contend that the payment was really a way to compensate them for their 2010 crop payment deficiency.
The walnut farmer’s contention is very interesting. Essentially you can draw two scenarios from the information that has been provided so far:
Scenario 1. The walnut farmers’ were indeed paid in full for their 2010 crop and the “momentum payment” was truly a pre-payment for the farmer’s 2011 crop.
Scenario 2. Diamond insidiously understated 2011 accounts payable to walnut farmers as a way to bolster their 2011 net income.
Potentially Fraudulent 2011 Financial Statements
The remainder of this report will focus on scenario 2. So what’s the big deal? Why would Diamond want to make their income statement look better? Recall the acquisition of Pringle chips from P&G When Diamond announced on April 2011 that it was going to acquire Pringle chips form P&G, its stock surged. Unfortunately, according to Andrejczak of MarketWatch magazine (2011, November 2), Diamonds’ decline in stock value from its high of $94 to a low of $38.30, erased over $1 billion in shareholder value. This means that Diamond will now need to take on substantially more debt than prior to the fall of its stock price. The acquisition of Pringle chips was valued at $2.35 billion in stock when it was announced in April 2011.
The Effects of Potential Fraud.
Immediately after Diamonds’ November 1, 2011 statement, numerous law firms published press releases regarding legal action against Diamond Foods, Inc. For example, according to Business Wire (2011, November 8), Bernstein Liebhard LLP “announced a lawsuit had been filed in the United States District Court for the Northern District of California on behalf of a class of investors who purchased Diamond Foods, Inc. securities between the period of April 5, 2011 and November 1, 2011”. These dates coincide with the Diamonds announcement of the Pringles chip acquisition and Diamonds November 1, 2011 disclosure. The complaint alleges the following:
1) The company was underestimating the ultimate price to be paid to walnut growers;
2) The company was improperly accounting for its cost of sales;
3) As a result, the company’s financial results were overstated;
4) The company lacked adequate internal and financial controls
5) As a result of the foregoing, the company’s financial statements were materially false and misleading at all relevant time; and
6) As a result of the foregoing, the company’s positive statements about Diamonds Foods’ business, operations, and prospects, as well as those regarding the timetable for the Acquisition [sic], lacked a reasonable basis.
P&G stock was affected a slightly with Diamonds’ disclosure and on Monday, November 7, 2011 it issued a statement reiterating its intention to sell Pringles chips to Diamond Foods. What is interesting about this case is that if Pringles original acquisition price is $2.35 billion, and Diamond stock value fell by $1 billion within the month of October, then Diamond will now have to shore up $1 billion in other debt to make up the difference. This, of course, if Diamond stock does not continue to fall.
Conclusion
It is amazing the amount of risk Diamonds’ leadership was willing to take with its purchase of Pringles chips and its quest to expand its market share. Table 3 shows how much Diamonds’ stock price has plunged since its disclosure with its November 10, 2011, closing price at $37.52 Also, its Price/Earnings ratio dropped from a high of $23.35 to $16.90. Furthermore, it is clear that the three elements of the Fraud Triangle were present in Diamond’s leadership during the past year. The perceived pressure was to expand its market share by aggressively acquiring bigger business of similar product. The perceived opportunity was the perceived financial gain was going to make, especially with the purchase of Pringles chips. The rationalization lies within the leadership of the company. With the deluge of lawsuits that Diamond Inc. is facing coupled with its market value loss of over $1 billion, I do not think they will recover from this blow. Not only does Diamond now have to raise over $1 billion is debt that was loss with its stock price plunge, I now faces numerous costly lawsuits that will drain the financial resources of the company. Unfortunately, I do not see a happy ending to this story. It is important to note the Diamond Inc., has not been indicted of a crime; however, there are numerous lawsuits that have been initiated.
Table -1. Diamonds’ net sales were as follows (in millions):
Year Ended July 31,
2010 2009 2008
Snack $ 321.4 $ 188.9 $ 88.6
Culinary 217.5 241.9 239.9
In-shell 31.5 34.3 41.9
Total Retail 570.4 465.1 370.4
International Non-Retail 69.2 68.9 101.6
North American Ingredient/Food Service 38.0 34.5 56.9
Other 2.6 2.4 2.6
Total Non-Retail 109.8 105.8 161.1
Total Net Sales $ 680.2 $ 570.9 $ 531.5
Source: Diamond Foods Inc. 2010 Annual Report.
Table - 2. Diamonds’ stock price from December 2008 through November 2011.
Source: Created with Stockcharts.com. Retrieved from http://stockcharts.com/h-sc/ui?s=DMND&p=
D&yr=3&mn=0&dy=0&id=p87054293865
References
Alpert, B. (2011, November 5). Getting to the nut of the problem. Barron.com. 1-3. Retrieved from http://online.barrons.com/article/SB500014240527487042
70204577013933878950486.html
Andrejczak, M. (2011, November 2). Diamond Foods cracks under audit probe. MarketWatch. 1-1. Retrieved from http://www.marketwatch.com/story/diamond-foods-cracks-under-audit-probe-2011-11-02
Business Wire (2011, November 8). Bernstein Liebhard LLP announces filing of class action against Diamond Foods, Inc. Retrieved from http://www.marketwatch.com/ story/bernstein-liebhard-llp-announces-filing-of-a-class-action-against-diamond-foods-inc-2011-11-08
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