P&G’s Pringles partner warrants careful taste test

September 27, 2011

By Jeffrey Goldfarb
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

What could be wrong with combining chips and nuts? Maybe a few things, in the case of Procter & Gamble’s complex $2.4 billion deal to offload its Pringles chips brand to snack purveyor Diamond Foods. As part of the tax-efficient transaction, the consumer giant wants investors to swap some of their stock for shares in Diamond. This might seem like a no-brainer given Diamond’s recent sparkle. Its share price has climbed more than fourfold since it went public in 2005, compared with the modest 12 percent gain for P&G over the same span.

Based on Diamond’s current stock price, once fattened up with Pringles, the company’s enterprise value will be more than 14 times proforma EBITDA for the 12 months to July 31 this year. That’s a big multiple for a food company, indicative of heady growth expectations. What’s more, P&G shareholders are likely to be offered Diamond shares at an enticing discount.

Still, over a third of Diamond’s shares are out on loan, which suggests plenty of short-sellers have the company in their sights. The shorts aren’t necessarily right, but there are oddities at the nut purveyor that P&G owners might want to scrutinize.

First, Diamond’s trade receivables have been growing faster than sales. At the July 31 year-end, these assets represented 42 percent of its fiscal fourth-quarter revenue, against 29 percent two years ago. It’s true that Diamond has been expanding overseas where payment terms are looser. But in theory such a trend also can indicate that more products are being distributed than can actually be sold.

In addition, there’s the curious change to the estimated costs of the Pringles deal. Diamond said in April these would be about $100 million over two years. As mergers develop, companies typically find more savings, not expenses. Earlier this month, however, Diamond revised the cost estimate upward to $150 million. The company’s head of investor relations says one figure is pre-tax and the other post-tax. The distinction, however, isn’t spelled out either in press releases or in documents submitted to regulators.

Perhaps most significant is the matter of payments to walnut growers. Diamond’s long-term contracts give it great leeway to determine a final price at the end of the crop year. And while walnut prices have been rising thanks to Chinese demand, they are among the most opaque in the agricultural world and can vary widely.
But growers contacted by Breakingviews say Diamond’s rates, based on a closing payment on Aug. 31 for the previous year’s crop, undercut competitors by at least a third, a far bigger discount than is typical. Based on Diamond’s estimated market share, this makes the company’s costs around $60 million lower than they would be had Diamond paid something closer to rivals. Considering that Diamond’s adjusted operating income for the year ended July 31 was about $110 million, that kind of difference is potentially significant.

The company’s accounts also suggest its walnut costs have shrunk appreciably. Diamond doesn’t break out these costs at the end of the year, but it reports a liability to walnut growers in its first quarter, a gauge of what it expects to pay. In the most recent fiscal year, that figure was about 25 percent lower than the year before. Meanwhile Diamond’s sales of nuts, a line item that includes more than just walnuts, grew by 15 percent. The implication could be that the gross profit margin on walnuts has expanded significantly.

Stranger still was a substantial follow-up payment by Diamond to walnut growers just two days after its Aug. 31 outlay. Diamond called this a “momentum payment,” a term new to growers, who say they’re not sure whether the extra check means they’re getting a better price for last year’s crop or that cashing it obligates them to deliver walnuts for the coming year. Diamond’s IR chief says the period to which the September payment applies is “somewhat of a blur” because the company sees it in the context of its three, five and 10-year contracts with growers.

Diamond may not be too worried about confused growers. The one-time walnut collective has culled their ranks by as much as 40 percent since going public. The Pringles deal also shows Diamond is trying to diversify further away from its century-old nuts heritage. But how the company packages its “momentum payment” in financial reports surely matters to P&G shareholders as they consider switching into Diamond stock. Along with other financial wrinkles, they should subject the deal to a careful taste test.

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