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TheStreet Open House

Diamond Foods Choked on Pringles

Casting aside accountancy issues that make it so two years of Diamond Foods' previous financial statements "should no longer be relied upon," according to its audit committee, the company's peril may be a result of taking on too much risk with its Pringles acquisition.

When Diamond Foods cut the deal, it simultaneously arranged a $500 million term loan and a $550 million revolving credit facility with its bankers for the purpose of funding the deal, and the $850 million in debt that came with it. Those loans were subject to covenants that forced the company to have financial leverage below 4.5 times earnings before interest taxes depreciation and amortization (EBITDA) into 2013 and less thereafter. After entering the deal, Diamond Foods said it expected leverage of less than 4 times EBITDA. However, in reaction to Wednesday's findings, analysts said that the accounting change would cause a breach of the covenant, signaling a thin margin for error.

Rapid Ratings Chief Executive James Gellert said that Diamond Foods warranted a high risk rating in 2010, while it's yet-to-be restated 2011 earnings signaled medium risk. Moody's, Fitch and Standard & Poor's do not have ratings for Diamond Foods since the company hasn't issued corporate bonds.

"We assume that the net $40 million EBITDA reduction caused a violation of DMND's debt covenants," wrote Jefferies analyst Thilo Wrede in a Thursday note. Wrede calculates that the company's interest rate could more than double to 10% following a debt restructuring, shaving off 91 cents in earnings per share. In addition, Wrede estimates that Diamond Foods is liable for $66 million in fees to Procter & Gamble if the Pringles acquisition fails, which he considers likely. He gives Diamond Foods a share valuation of $27 with a "hold" rating.

After hearing of the audit committee findings, Procter & Gamble spokesman Paul Fox said Wednesday of the Pringles deal with Diamond Foods: "We're keeping all options open." The company said that it had received inquries about its Pringles business by interested parties, without adding further detail. Bloomberg reports that Procter & Gamble will seek a termination of the deal, citing unnamed sources.

"If cancelled, options for the Pringles business are to sell Pringles to another buyer or continue to operate the profitable business. Either option is likely be a better deal for shareholders than the DMND transaction, given DMND's current share price," wrote Wells Fargo analyst Timothy Conder in a Thursday note.

PepsiCo (PEP) is the market leader in the salty snacks with its Frito Lays, Doritos and Ruffles brands. Meanwhile, snacks and cereals company Ralcorp (RAH) recently completed a spin of its Post cereals business, an acquisition of Sara Lee's (SLE) refrigerated doughs business and spurned a $94 a share takeover from ConAgra Foods (CAG) in September.

Kraft Foods (KFT) also has large salty snacks businesses with its Ritz, Triscuit, Nabisco and Wheat Thins brands. For more on snack foods M&A see, three deals that changed everything and the 5 most M&A crazy companies since the financial crisis.

San Francisco- based Diamond Foods sells Kettle Brand potato chips, Emerald nuts and snacks and Pop- Secret popcorn. With Pringles added, the company had expected to earn up to $4 in earnings per share by 2015 on greater than $2.4 billion in revenue. "The addition of Pringles business is transformational to Diamond and its shareholders," said Diamond Foods then CEO Mendes when announcing the deal.

In 2008, Diamond Foods bought Pop Secret for $190 million and it bought Kettle Foods from Lion Capital in 2010, opening a an equal sized line of credit with its current creditors for the purchase.

While full audit committee findings haven't been released publicly and agencies investigating Diamond Foods accounting haven't made public rulings, the impact of internal review on loan covenants signals that the company was operating on a close margin.

The price of Diamond Foods shares was also a key to the $1.5 billion stock portion of the deal, which could significantly change the company's financial leverage, even if earnings waned. The stock piece of the acquisition priced at roughly $51.47 a Diamond Foods share, but could change in value within a share price "collar", impacting the debt component of the deal. If the company's shares were above the top end of the exchange offer, then the company would contribute its shares at a value of roughly $56.62, shaving $200 million in debt. However, if shares faltered and were near the lower bound of $45.60, Diamond Foods would assume an additional $150 million in debt.

The collar arrangement on Diamond Foods share price was a result of the tax-free "Reverse Morris Trust" deal structure, which forced Procter & Gamble shareholders to have a greater than 50% share in Diamond Foods, limiting the benefit of the company's share price appreciation. Nevertheless, a drop in Diamonds shares, would make the total debt component of the deal equal to its entire bank financing arrangement "The amount of debt to be assumed by Diamond could increase by up to $200 million or decrease by up to $150 million based on this adjustment mechanism," the company said in a press release announcing the deal.

A November article article by Barrons pointed to a connection between Diamond Foods pending Pringles deal and the "momentum payments" that the company's audit committee has now deemed improper.

All told, as Diamond Foods now negotiates with its creditors, the irony is that one of the company's most immediate risks comes from loan financings for a deal is no longer expected to happen.

The company's troubles started in earnest in November, when it revealed an audit committee investigation into "momentum" payments made to its walnut suppliers. A flurry of shareholder lawsuits followed. However, Diamond Foods share slide began when the company began disclosing the payments in October filings that contained little explanatory detail.

Diamond Foods shares briefly surged in December when results of an investigation by tax attorney Robert Willens included in a KeyBank analyst report by Akshay S. Jagdale signaled that the company's accounting inquiry wouldn't lead to restatements. About the audit committee's findings, Willens said "They must have found something that cast doubt on the validity of the supplier contracts." Improper emails, letters or utterances could have caused the contracts to be superseded, Willens added.

A SEC investigation into Diamond Foods' accounting practices was formally disclosed by the company shortly thereafter in mid-December. In mid-January, Bloomberg reported that the DoJ could also open an inquiry.

Still to be seen is what Diamond Foods next steps are with lenders, regulatory authorities or shareholders. However, as the company battles for its life, its April acquisition of Pringles may turn out to be a key seed of its demise. It is unclear from the company's audit committee investigation whether accounting misstatements were intentional or not.

Spokespeople for Bank of America, Alix Partners and Barclays declined to comment to queries on debt negotiations, other lenders didn't respond to requests for comment on loan agreements. Diamond Foods did not respond to emails seeking added comment on its audit committee findings.

-- Written by Antoine Gara in New York

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