Market Overview

How Can Diamond Foods Buy Pringles Now?

Diamond Foods (NASDAQ: DMND) fell to a new 52-week low with over 14.4 million shares trading hands as investors respond to an inspection of the company's books following a shareholder suit against the company's directors. The stock is down over 35 percent in early morning trading after auspiciously closing at $36.66 on Wednesday.

A three-month investigation by the Securities and Exchange Commission into the company concluded that around $80 million in payments to walnut growers were not accounted for in August 2010 and September 2011, raising questions of whether further inaccuracies exist in the firm's books. It also raises questions over whether Diamond will be able to expand its growing snack empire.

After the accounting probe concluded that the company failed to account for payments to walnut growers, CEO MIchael Mendes and CFO Steve Neil were fired. The firm has already replaced both executives, and Lead Independent Director Robert J. Zollars has been elected the company's chairman. The company has also announced that it will restate earnings results for 2010 and 2011 to correct for the accounting errors.

The accounting irregularities took investors by surprise, as the stock was rallying last year after the company announced its plans to buy Pringles from Procter & Gamble (NYSE: PG) for around $1.5 billion. The profitable chip brand has a major global presence and would bolster Diamond's snack food offerings such as its Kettle Chips brand, which has grown in popularity in U.S. markets.

The potato chip deal may fall through, now that the probe has given its damning conclusion. Previously, Procter & Gamble had said that they would hold out for the probe to conclude the deal, but that it was dependent upon a favorable conclusion from the auditing committee. Now that wrongdoing has been confirmed, the deal may fall through. P&G has said that the probe's conclusion is "very disappointing," and analysts are now assuming that the deal will not happen.

Despite the company's popular products, many investors will steer clear of the company. After news of the probe's findings broke yesterday, investment advisor Josh Brown tweeted "on any accounting red flag, no matter what, automatic sell and don't buy. NO EXCEPTIONS EVER." Accounting irregularities, no matter how small, raise questions over the reliability or earnings and revenue statements, which are the bloodline of all but the most speculative investor.

The accounting irregularity will also raise questions on how sustainable the company's current operations are. According to the company's earnings release, its profit margin has been falling despite higher sales. At $232.8 million in net sales for Q3 2011 compared to $176.6 million for the same period in 2010, the company has seen explosive growth in demand, but sales costs also rose 32.3 percent. As a result, the company's 24.5% gross profit margin was slightly below the previous year's margin of 24.8%.

Now, we know these numbers are all imaginary, and the reality is probably much worse. Without a Pringles acquisition to help the company grow out of its shrinking margin problem, it will likely face greater pressure to yield profits and maintain any growth in market share.

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