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DMND > SEC Filings for DMND > Form 10-Q on 9-Dec-2013All Recent SEC Filings

Show all filings for DIAMOND FOODS INC

Form 10-Q for DIAMOND FOODS INC


9-Dec-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are an innovative packaged food company focused on building and energizing brands. We specialize in processing, marketing and distributing snack products and culinary, in-shell and ingredient nuts. In 2004, we complemented our strong heritage in the culinary nut market under the Diamond of California® brand by launching a line of snack nuts under the Emerald® brand. In 2008, we acquired the Pop Secret® brand of microwave popcorn products, which provided us with increased scale in the snack market. In 2010, we acquired Kettle Foods, a leading premium potato chip company in the two largest potato chip markets in the world, the United States and the United Kingdom, adding the complementary premium Kettle Brand ® to our existing portfolio.

Our business is seasonal. In sourcing walnuts, we contract directly with growers for their walnut crop. We typically receive walnuts during the period from September to November, and we pay for the crop throughout the year in accordance with our walnut purchase agreements with the growers. We typically receive in-shell pecans during the period from October to March, and shelled pecans throughout the fiscal year, and pay for them over those periods on receipt. As a result of this seasonality, our personnel and walnut inventories peak during the last four months of the calendar year. We experience seasonality in capacity utilization at our Stockton, California facility associated with the annual walnut harvest and seasonal in-shell and culinary product demand. Generally, we receive and pay for approximately 50% of the corn for popcorn in November and approximately 50% in April. We contract for potatoes and oil annually and at times throughout the year and receive and pay for supply throughout the year.

During the preparation of the first quarter fiscal 2014 Form 10-Q, we determined that the statutory income tax rate used to value United Kingdom deferred taxes was not correct as of July 31, 2013. This is due to a change in the statutory tax rate enacted in the fourth quarter of fiscal 2013, which resulted in a $3.2 million overstatement of the net deferred income tax liability balance at July 31, 2013 and a $3.3 million understatement of the income tax benefit for the year. We assessed the materiality of the error in accordance with Securities and Exchange Commission ("SEC") Staff Accounting Bulletin No. 99, Materiality and concluded that this error was not material to the Fiscal 2013 consolidated financial statements. In accordance with SEC Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements, due to the immaterial nature of this error, on both prior and projected current year results, we elected to revise the July 31, 2013 Consolidated Balance Sheet included in this filing and we will revise the 2013 consolidated financial statements when our fiscal 2014 Annual report on Form 10-K is filed.

Results of Operations

The Company's chief operating decision maker ("CODM") changed during the fourth quarter of fiscal 2012 and in the second quarter of fiscal 2013 there was a change in the information used by the CODM to make decisions about the allocation of resources and the assessment of performance. As a result, during the second quarter of fiscal 2013, we changed our operating and reportable segments. We previously had one operating segment and one reportable segment; we now aggregate our operating segments into two reportable segments, which are Snacks and Nuts. The Snacks reportable segment predominately includes products sold under Kettle U.S., Kettle U.K. and Pop Secret. The Nuts reportable segment predominantly includes products sold under Emerald and Diamond of California. The Company evaluates the performance of its segments based on net sales and gross margin for each segment. Gross profit is calculated as net sales less all cost of sales.


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Our net sales and gross profit by segment for the periods identified below were as follows (in thousands):

                                  Three Months Ended
                                      October 31,           % Change from
                                  2013          2012        2012 to 2013
                 Net sales
                 Snacks         $ 112,589     $ 111,243           1%
                 Nuts             122,079       147,219         -17%

                 Total          $ 234,668     $ 258,462          -9%

                 Gross profit
                 Snacks         $  39,424     $  38,287           3%
                 Nuts              18,509        20,259          -9%

                 Total          $  57,933     $  58,546          -1%

For the three months ended October 31, 2013, Snacks segment net sales remained relatively consistent at $112.6 million from $111.2 million for the three months ended October 31, 2012.

For the three months ended October 31, 2013, Nuts segment net sales decreased to $122.1 million from $147.2 million for the three months ended October 31, 2012, primarily driven by decreases in volume of 20.3%. The decline in volume was primarily driven by planned reductions in SKUs and lower walnut supply.

Sales to our largest customer, Wal-Mart Stores, Inc. (which includes sales to both Sam's Club and Wal-Mart), represented approximately 13.5% and 19.4% of total net sales for the three months ended October 31, 2013 and 2012, respectively. No other customer accounted for 10% or more of our total net sales for those periods.

The impact of foreign exchange on our net sales for the three months ended October 31, 2013 and 2012, was not significant.

Gross profit. Snacks segment gross profit as a percentage of net sales was 35.0% and 34.4% for the three months ended October 31, 2013 and 2012, respectively. The increase reflects continued progress in reduction of unit processing costs based on cost reduction initiatives.

Nuts segment gross profit as a percentage of net sales was 15.2% and 13.8% for the three months ended October 31, 2013 and 2012, respectively. The increase reflects our focus on increasing net price realization, rationalization of lower performing SKUs, and our cost savings initiatives, offset in part by an increase in commodity costs.

Selling, general and administrative. Selling, general and administrative expenses consist principally of salaries and benefits for sales and administrative personnel, brokerage, professional services, travel, non-manufacturing depreciation and facility costs. Selling, general and administrative expenses were $56.6 million and $38.2 million and 24.1% and 14.8% as a percentage of net sales for the three months ended October 31, 2013 and 2012, respectively. Selling, general and administrative expenses increased primarily due to the $23.5 million loss associated with the change in fair value of the Securities Settlement. Additionally, in the first quarter of fiscal 2014, we recorded an estimated $5.0 million liability associated with the Securities and Exchange Commission investigation. The increase in Selling, general and administrative expenses was partially offset by the $1.6 million gain recorded within the Selling, general and administrative line item relating to the shareholder derivative settlement in the first quarter of fiscal 2014. Furthermore, no costs related to the Audit Committee investigation and related legal expenses were incurred as compared to prior year.

Advertising. Advertising costs were $10.7 million and $9.0 million for the three months ended October 31, 2013 and 2012 respectively. Advertising expenses as a percentage of net sales were 4.5% and 3.5% for the three months ended October 31, 2013 and 2012, respectively. The increase was primarily due an increase in online holiday spending in support of Diamond of California and an increase for in-store demonstrations in support of the Emerald brand re-launch.

Loss on warrant liability. Loss on warrant liability was $17.0 million and $7.5 million, and 7.2% and 2.9% of net sales, for the three months ended October 31, 2013 and 2012, respectively, due to the change in the fair value of the warrant liability.

Interest expense, net. Net interest expense was $14.8 million and $13.9 million, and 6.3% and 5.4% of net sales, for the three months ended October 31, 2013, and 2012 respectively. The increase was primarily due to our election of the payment-in- kind interest on the Oaktree debt.


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Income taxes. Our effective tax rates for the three months ended October 31, 2013 and 2012, were approximately (2.6%) and (6.1%), respectively. The difference between the effective tax rate and the statutory rate of 35%, in these periods, was primarily due to the valuation allowance which was provided to reduce United States and state deferred tax assets to amounts considered recoverable and the change in domestic deferred taxes resulting from the Company's long lived intangibles' amortization.

The tax provision for the three months ended October 31, 2013, was calculated on a jurisdiction basis. We estimated the United Kingdom income tax provision using the effective income tax rate expected to be applicable for the full year. We estimated the United States (U.S.) income tax provision using the discrete method provided in ASC 740, as a reliable estimate of the U.S. annual effective tax rate could not be made, primarily due to the unpredictable trends existing within the Company's net income(loss) positions due to the above mentioned selling, general and administrative expenses recorded and their impact on results from operations.

Liquidity and Capital Resources

Our liquidity is dependent upon funds generated from operations and external sources of financing.

Cash provided by operating activities was $12.8 million during the three months ended October 31, 2013, compared to $8.2 million cash provided by operating activities for the three months ended October 31, 2012. The change from cash provided by operating activities was primarily due to an increase in payable to growers partially offset by in an increase in inventories and trade receivables. Additionally, there were non-cash reconciling items to net income in the first quarter of fiscal 2014 that did not occur in the first quarter of fiscal 2013 such as the Securities Settlement, and the potential SEC penalty. Cash used in investing activities was $1.3 million during the three months ended October 31, 2013, compared to $2.9 million for the three months ended October 31, 2012. The lower cash used in investing activities was primarily due to the completion of our Beloit, Wisconsin plant expansion in the first quarter of fiscal 2013. In addition, cash used in financing activities was $5.5 million during the three months ended October 31, 2013, compared to $1.3 million cash provided by financing activities during the three months ended October 31, 2012, primarily due to increased paydowns under the revolving credit facility.

In February 2010, we entered into an agreement with a syndicate of lenders for a five-year $600 million secured credit facility (the "Secured Credit Facility"). We used the borrowings under the Secured Credit Facility to fund a portion of the Kettle Foods acquisition and to fund ongoing operations. Our Secured Credit Facility initially consisted of a $200 million revolving credit facility and a $400 million term loan. In March 2011, the syndicate of lenders approved our request for a $35 million increase in our revolving credit facility to $235 million, under the same terms. In August 2011, the syndicate of lenders approved our request for a $50 million increase in our revolving credit facility to $285 million, under the same terms. The revolving credit facility was reduced from $285 million to $255 million as part of the Third Amendment. The capacity under the revolving credit facility decreased to $230 million effective July 31, 2013, and is scheduled to decrease $180 million effective January 31, 2014. As of October 31, 2013, the revolving credit facility had $230 million in capacity, of which $150 million was borrowings outstanding. In May 2012, we made a $100 million pre-payment on the term loan facility as part of the Third Amendment. As of October 31, 2013, the term loan facility had $215 million in capacity, of which $215 million was outstanding. In addition, scheduled principal payments on the term loan facility are $0.9 million (due quarterly), with the remaining principal balance and any outstanding loans under the revolving credit facility to be repaid on February 25, 2015. Substantially all of our tangible and intangible assets are considered collateral security under the Secured Credit Facility.

The Secured Credit Facility provides for customary affirmative and negative covenants and cross default provisions that may be triggered, if we fail to comply with obligations under our other credit facilities or indebtedness. Beginning on October 31, 2013, our senior debt to consolidated EBITDA ratio ("Consolidated Senior Leverage Ratio"), as defined in the Third Amendment, will be limited to no more than 4.70 to 1.00 and our fixed charge coverage ratio to no less than 2.00 to 1.00. The Consolidated Senior Leverage Ratio covenant will decline each quarter, ultimately to 3.25 to 1.00 in the quarter ending July 31, 2014.

In December 2010, Kettle Foods obtained, and we guaranteed, a 10-year fixed rate loan (the "Guaranteed Loan") in the principal amount of $21.2 million, of which $10.0 million was outstanding as of October 31, 2013. Principal and interest payments are due monthly throughout the term of the loan. The Guaranteed Loan was being used to purchase equipment for our Beloit, Wisconsin plant expansion. Borrowed funds were placed in an interest-bearing escrow account and were made available as expenditures were approved for reimbursement. As the cash was used to purchase non-current assets, such restricted cash was classified as non-current on the balance sheet. In December 2012, the remaining balance within the escrow account was released back to the lender and was used to pay down the outstanding loan balance. Also, as part of the paydown, we paid a 4% prepayment penalty, which was recorded in interest expense.


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The Guaranteed Loan provides for customary affirmative and negative covenants, which are similar to the covenants under the Secured Credit Facility. The financial covenants within the Guaranteed Loan were reset to match those in the Third Amendment.

In March 2012, we reached an agreement with our lenders to forbear from seeking any remedies under the Secured Credit Facility with respect to specified existing and anticipated non-compliance with the credit agreement and to amend our credit agreement ("Second Amendment"). Under the amended credit agreement, we had continued access to our existing revolving credit facility through a forbearance period (initially through June 18, 2012) subject to our compliance with the terms and conditions of the amended credit agreement. During the forbearance period, the interest rate on borrowings increased. The credit agreement required us to suspend dividend payments to stockholders. In addition, we paid a forbearance fee of 25 basis points to our lenders. The forbearance period concluded on May 29, 2012, when we closed agreements to recapitalize our balance sheet with an investment by Oaktree Capital Management, L.P. ("Oaktree").

The Oaktree investment initially consists of $225 million of newly-issued senior notes and a warrant to purchase approximately 4.4 million shares of Diamond common stock. The senior notes will mature in 2020 and bear interest at 12% per year that may be paid-in-kind at our option for the first two years. Oaktree's warrant became exercisable at $10 per share starting on March 1, 2013.

The Oaktree agreements provided that if we secured a specified minimum supply of walnuts from the 2012 crop and achieved profitability targets for our nut businesses for the six month period ended January 31, 2013, the warrant would be cancelled and Oaktree would have had the ability to exchange $75 million of the senior notes for convertible preferred stock of Diamond (the "Special Redemption"). The convertible preferred stock would have had an initial conversion price of $20.75, which represented a 3.5% discount to the closing price of our common stock on April 25, 2012, the date that we entered into our commitment with Oaktree. The convertible preferred stock would have paid a 10% dividend that would be paid in-kind for the first two years. The warrant is accounted for as a derivative liability with gains or losses included in (gain) loss on warrant liability in our Statements of Operations. Based on our operating results for the six months ended January 31, 2013, the Special Redemption did not occur.

Pursuant to the Oaktree agreements, we were permitted to prepay all (but not part) of the principal on the Oaktree notes at a 1% premium prior to May 29, 2013. Beginning on May 29, 2013, the applicable premium increased to 12% and would be applied to any prepayments of principal (including partial prepayments). This premium will reduce to 6% on May 29, 2016, 3% on May 29, 2017, and nil on May 29, 2018. The Oaktree agreements do not impose any covenants incremental to those under the Secured Credit Facility. As of October 31, 2013, we would pay a prepayment penalty of $31.3 million, excluding accrued interest, on the Oaktree notes.

On May 22, 2012, we entered into the Waiver and Third Amendment to its Secured Credit Facility ("Third Amendment"), which provided for a lower level of total bank debt, initially at $475 million, along with substantial covenant relief until October 31, 2013. At that time, these covenants will become applicable at revised levels set forth in the Third Amendment (initially 4.70 to 1.00 for the Consolidated Senior Leverage Ratio, declining each quarter ultimately to 3.25 to 1.00 in the quarter ending July 31, 2014 and thereafter, and 2.00 to 1.00 for the fixed charge coverage ratio for each fiscal quarter). The Third Amendment included a new covenant requiring that we have at least $20 million of cash, cash equivalents and revolving credit availability at all times beginning February 1, 2013. In addition, the Third Amendment required a $100 million pre-payment of the term loan facility, while reducing the remaining scheduled principal payments on the term loan facility from $10 million to $0.9 million. The Third Amendment also amended the definition of "Applicable Rate" under the Secured Credit Agreement (which sets the margin over LIBOR and the Base Rate at which loans under the Secured Credit Agreement bear interest). Initially, Eurodollar rate loans bore interest at 5.50% plus the LIBOR for the applicable loan period, and base rate loans bore interest at 450 basis points plus the highest of (i) the Federal Funds Rate plus 50 basis points, (ii) the Prime Rate, or (iii) Eurodollar Rate plus 100 basis points. The LIBOR rate is subject to a LIBOR floor, initially 125 basis points (the "LIBOR Floor"). The Applicable Rate will decline, if and when we achieve specified reductions in our Consolidated Senior Leverage Ratio, as defined in the Third Amendment. The Third Amendment also eliminated the requirement that proceeds of future equity issuances be applied to repay outstanding loans and waived certain covenants in which we were non-compliant in connection with our restatement of our consolidated financial statements.

The Secured Credit Facility and the Securities Purchase Agreement, dated as of May 22, 2012, by and between Diamond and OCM PF/FF Adamantine Holdings, Ltd. (the "Oaktree SPA") provide for customary affirmative and negative covenants, and cross default provisions that may be triggered, if we fail to comply with obligations under our other credit facilities or indebtedness. The Secured Credit Facility and the Oaktree SPA included a covenant that restricts the amount of other indebtedness (including capital leases and purchase money obligations for fixed or capital assets), to no more than $25 million. The accounting treatment for the seven-year equipment lease for our Salem, Oregon plant (the "Kettle U.S. Lease") and the five-year equipment lease for our Norfolk, United Kingdom plant (the "Kettle U.K. Lease") caused us to be in default of the covenants limiting other indebtedness. These defaults were waived, with respect to the Kettle U.K. Lease on July 27, 2012 ("Fourth Amendment"), and with respect to the Kettle U.S. Lease on August 23, 2012 ("Fifth Amendment"). Additionally, the Secured Credit Facility and the Oaktree SPA were each amended to allow the Company to incur up to $31 million of capital leases and purchase money obligations for fixed or capital assets,


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which amount will be reduced from and after December 31, 2013 (a) to $25 million under the Secured Credit Facility and (b) to $27.5 million under the Oaktree SPA. As of October 31, 2013, the Company was compliant with financial and reporting covenants as provided by the Secured Credit Facility.

Working capital and stockholders' equity were ($89.4) million and $140.0 million at October 31, 2013, compared to ($59.5) million and $170.0 million at July 31, 2013, and $68.5 million and $322.1 million at October 31, 2012. The decrease in working capital between October 31, 2013 and October 31, 2012 was primarily due to changes in fair value of the private securities class action stock settlement and the warrant liability.

We believe our cash and cash equivalents, cash expected to be provided from our operations, borrowings available under our Secured Credit Facility and restricted cash provided by the Guaranteed Loan, will be sufficient to fund our contractual commitments, repay obligations as required and fund our operational requirements for at least the next 12 months.

Contractual Obligations and Commitments

Contractual obligations and commitments at October 31, 2013, were as follows (in
millions):



                                                                Payments Due by Period
                                                        Remainder      FY 2015       FY 2017
                                           Total         FY 2014       FY 2016       FY 2018       Thereafter
Revolving line of credit                     150.0              -         150.0            -                -
Long-term obligations (a)                    509.7             5.3        215.7           3.5            285.2
Interest on long-term obligations (b)        225.3            20.4         73.6          68.6             62.7
Capital leases                                12.6             1.8          5.2           4.2              1.4
Interest on capital leases                     2.2             0.6          1.1           0.4              0.1
Operating leases                              30.4             3.4          7.8           6.9             12.3
Purchase commitments ( c)                     71.8            65.3          6.5            -                -
Pension liability                              8.6             0.5          1.5           1.6              5.0
Long-term deferred tax liabilities (d)       106.0              -            -             -             106.0
Other long-term liabilities (e)                5.9             1.2          1.8           1.6              1.3

Total                                      1,122.5            98.5        463.2          86.8            474.0

(a) Amount does not reconcile to consolidated balance sheet as of October 31, 2013, due to paid-in-kind interest that is presented within the long-term obligations financial statement line item on the consolidated balance sheets.

(b) Amounts represent the expected cash interest payments on our long-term debt. Interest on our variable rate debt was forecasted using a LIBOR forward curve analysis as of October 31, 2013.

(c) Commitments to purchase inventory and equipment. Excludes purchase commitments under Walnut Purchase Agreements.

(d) Primarily relates to the intangible assets of Kettle Foods.

(e) Excludes $0.1 million in deferred rent liabilities. Additionally, the liability for uncertain tax positions ($1.4 million at October 31, 2013, excluding associated interest and penalties) has been excluded from the contractual obligations table because a reasonably reliable estimate of the timing of future tax settlements cannot be determined.

Effects of Inflation

There has been no material change in our exposure to inflation from that discussed in our 2013 Annual Report on Form 10-K.

Critical Accounting Policies

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. Our critical accounting policies are set forth below.


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Revenue Recognition and Accounts Receivable. We recognize revenue when persuasive evidence of an arrangement exists, title and risk of loss has transferred to the buyer, price is fixed, delivery occurs and collection is reasonably assured. Revenues are recorded net of rebates, introductory or slotting payments, coupons, promotion and marketing allowances. The amount we accrue for promotion is based on an estimate of the level of performance of the trade promotion, and is based upon factors such as historical trends with similar promotions, expectations regarding customer and consumer participation and sales and payment trends with similar previously offered programs. Customers have the right to return certain products. Product returns are estimated based upon historical results and are reflected as a reduction in sales.

Inventories. All inventories are accounted for on a lower of cost (first-in, first-out or weighted average) or market basis. We have entered into walnut purchase agreements with growers, under which they deliver their walnut crop to us during the fall harvest season, and pursuant to our walnut purchase agreements, we determine the price for this inventory after receipt and by the end of the fiscal year. This purchase price is determined by us based on our discretion provided in the agreements, taking into account market conditions, crop size, quality and nut varieties, among other relevant factors. Since the ultimate purchase price to be paid will be determined subsequent to receiving the walnut crop, we estimate the final purchase price for our interim financial statements. Those interim estimates may subsequently change due to changes in the factors described above and the effect of the change could be significant. Any such changes in estimates are accounted for in the period of change by adjusting inventory on hand or cost of goods sold if the inventory is sold through.

Property, Plant and Equipment. Property, plant and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of assets ranging from 30 to 39 years for buildings and ranging from 3 to 15 years for machinery, equipment and software.

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