Best in Class: Why Diamond Foods Is One Tasty Stock

NEW YORK ( TheStreet) -- Those looking for a smart play in the food sector could do a lot worse than putting Diamond Foods ( DMND) on their plate. Much like the foods it produces, Diamond Foods delivers a tasty bang for the buck.
Through targeted acquisitions, supply-chain retooling, shrewd marketing and, of course, highly addictive snack products, the Stockton, California-based food producer has -- despite its diminutive size, and in some ways because of it -- managed to carve a niche as a Best in Class food maker.

Over the past five years, since the close of its first day of trading in July of 2005, Diamond Foods has consistently proven that a company with fewer than 1,000 full-time employees can compete with the national giants. And its stock has reflected that success; during that time, Diamond Foods' share price is up over 70%.

A more recent success was the company's second fiscal quarter: On February 25, Diamond Foods reported earnings and revenue that both exceeded analysts' expectations. It earned 52 cents a share, or 41% higher than a year earlier, while its non-GAAP earnings grew 30% to 48 cents over the prior year, as sales shot up 22% to $184.2 million. The quarter's sales were driven by strong snack demand and the timing effect that a later walnut crop had on in-shell, ingredient and international sales.

Wall Street had expected Diamond Foods earnings of 47 cents a share on revenue of $169.44 million. The company has also upped its 2010 guidance to $1.79 to $1.83 a share from $1.75 to $1.83 a share on sales of $595 million to $610 million from $585 million to $605 million previously. The consensus forecast among equity analysts is $1.83 on revenue of $597.28 million.

A closer look at Diamonds Foods' second quarter release shows that food-store sales for its key Emerald Nuts brand grew 53% in the twelve months ended January 23, 2010, while national market share grew 260 basis points to 8.3%. This growth was achieved with only four SKUs (stock-keeping units) with more than 60% ACV ("all-commodity volume grocery distribution"-- a measure of reach in US grocery stores weighted by retail dollar sales.)

In other words: Diamond Foods is playing in the big leagues, while fielding only a handful of players. As to how it's doing it.....

It might be surprising to learn that Diamond Foods saw its Emerald snack brand grow 86% from the previous year and capture a record 10% share of the U.S. grocery store snack nut market for the period ended January 23rd. Surprising until you remember the Super Bowl ad:

A surreal water-park theme show. Flaming hoops. A bizarre carnival barker. Women in bikinis bobbing on the surface of the water, making like dolphins and being fed Emerald Nuts and Pop-Secret Popcorn as treats for performing tricks. The catchphrase: "AWESOME + AWESOME = AWESOMER." OK, so maybe the ad was a bit of a mess, but it was attention-grabbing.

And what you might not be aware of was the flood of additional marketing, circulars, promotions and other efforts all leading up to the 30-second spot.

This year companies paid more than $2 million for Super Bowl ads, but the payoff, according to Diamond Foods CEO Michael Mendes, was worth it. Mendes, who sat down with us to discuss his company's prospects in 2010, noted that when retailers see companies like Diamond Foods investing heavily in their brands with a Super Bowl ad, it helps the company get its products into the retailer and stay. This year, investors agreed and pushed the stock price up 11.5% in the past three months.

"The opportunity to try to drive sales velocity in that period is probably the lowest objective," Mendes says. Instead, building brand equity and seeing an impact for longer-term sales is the company's main objective.

Apparently, they know what they're doing. In 2005, Diamond Foods saw a lift in sales of over 50% in the four-week period during which it aired a Super Bowl ad; it received a similar Super Bowl-bolstered 68% sales lift in sales in 2007.

The risk this year for Diamond Foods' Super Bowl ad was in featuring both its Emerald Nuts and Pop Secret popcorn brand at the same time. The company had acquired the latter in September 2008 from General Mills ( GIS) for about $190 million in cash, banking on the fact that those who like its nuts would also be partial to microwaveable popcorn.

Indeed, Mendes says his company has a competitive edge through its ability to acquire orphan brands like Pop Secret -- brands with strong growth potential, but may not have been receiving the kind of attention they need to succeed in the shadow of a larger company.

Says Mendes: "We can take brands that maybe have been under-invested and are lacking innovation ... and reinvigorate these brands and build out their innovation pipeline to revitalize the consumer support." He notes that Diamond Foods focuses on brands that are nationally recognized and have the ability to support the growth of the company's other brands.

For example, when the company bought the Pop Secret brand, it already had a strong presence at a merchandise chain the Diamond Foods' Emerald brand didn't have a presence in. The acquisition helped Emerald get its foot in the door and even noticed by other competing mass merchandise chains. The company currently sells directly to groceries, mass merchandise chains and clubs. It has distribution in more than 80% of U.S. supermarkets. Diamond Foods is also the nation's top exporter of walnuts to Europe and the Pacific Rim.

The company's most recent acquisition was announced on Feb. 25, when it entered a definitive agreement to buy potato-chip maker Kettle Foods from investment firm Lion Capital for $615 million in cash. The markets, however, responded poorly to the move, on concerns the acquisition would branch out the company into unchartered territory. On Feb. 26, the share price fell 10.0% in a single day of trading, driving down the 1-month share performance by 5.7%.

Acquisitions have clearly helped the company grow, but Mendes notes that the key to its survival lies in a highly unglamorous part of the job: supply-chain infrastructure. "A lot of regional companies are able to handle a certain geographical area, but can't cover the national needs of a national retailer," Mendes says.

And while lack of size might seem a liability to some, Mendes argues that being small has its advantages too -- such as the ability of the company's various departments to be closely aligned. He encourages a culture where failure for the sake of innovation isn't punished.

"Sometimes we have to spend more money," he says. "Sometimes it will take longer for us to get our products ready. Sometimes we have to not launch a product." The successful launch of a product has at times been a process of trial-and-error for the company, as demonstrated by the first launch of its peanut line. The company first came out with very high-end, three-walled packaging in an 11-ounce canister, and it wasn't working.

"Our packaging was very good if you wanted to store your peanuts for three years. It was probably more packaging than peanuts require because they're an item that churns rapidly at grocery stores, and we couldn't see through the packaging. We realized that people wanted to see the product. So we tried another approach."

Likewise, in the process of attempting to revitalize its peanut line, the company tried out boldly flavored peanuts -- like chipotle and wasabi -- but soon learned that they only appealed to a small demographic. In a flash, the packing was gone, as were the funky flavors.

"To be a full line snack player, we have to have a strong competing item in the peanut segment because peanuts represents 40% of the volume and 30% of the dollar sales in the entire snack-nut category," Mendes explains.

Again, such flexibility appears to be paying dividends: Late last year, Diamond Foods said Emerald sales at U.S. food stores grew by more than 69% over the 4-week period ended November 28th, compared to the prior year period, with market share climbing 360 basis points to reach 10% for the first time in the brand's history. In the peanut category, which Emerald entered nationally in 2009, sales were up more than 50% and national share was over 3%. Emerald's two peanut items are now in over 50% ACV (or all-commodity volume) distribution.

Looking ahead, Diamond Foods, which repackaged its trail mix product as a convenient Breakfast on the Go item in 2008, will be launching the product at U.S. grocery channels this year -- which it sees as a $30 to $50 million opportunity.

As Mendes says: "Even in difficult times, people are looking for those small, affordable pleasures."

-- Reported by Andrea Tse in New York

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