Diamond Foods, Inc.

: A Comprehensive Case in Financial Analysis and Valuation

Abstract

This real-world case provides an opportunity for students to apply several concepts in financial
analysis and valuation to a real-world M&A context. It presents a platform to achieve several
learning objectives, including the development of critical thinking and problem-solving skills. By
requiring students to apply the frameworks of strategy and financial analysis, techniques of
accounting and financial analysis, and by placing students in the role of a financial analyst, the case
develops understanding of the challenges involved in financial analysis and valuation in a real-world
context. The case helps students to (a) experience the power of using publicly available information
to derive insights for firm valuation and (b) appreciate the significance of accounting analyses in
firm valuation.

Case

I think Diamond is still very interesting. This is a company that is growing rapidly.
It doesn’t look like any food company I’ve seen in 25 years of following the food
sector.
- Tim Rammy on cnbc.com video, September 22, 2011

Diamond appears to be losing its dominant position in the walnut industry. As a

result, its business model is deteriorating. Company profitability also appears to
be overstated due to accounting treatment of a prospective “momentum
payment”, which may be in lieu of a retrospective payment.

- Research report by Off Wall Street, September 25, 20111

It was the morning of Monday, September 26, 2011. Mark Jenkins was getting nervous. He had
just finished reading a report by Off Wall Street Consulting Group1 on Diamond Foods Inc.
(hereafter, Diamond, or the Company). The report stated that the “Company profitability appears
to be overstated due to the accounting treatment of “momentum” payments”, and changed the
firm’s recommendation on Diamond (Ticker: DMND) to ‘Sell’, and lowered the target price for
Diamond from $90 on the previous Friday (September 23, 2011) to $43.

1
The report can be accessed at https://www.offwallstreet.com/userfiles/files/ideas/NEW_DMND_9-25-11.pdf

1|Page
It had been almost two months since Mark had joined Progressive Capital, a boutique Wall Street
firm specializing in short-sale research. The first few weeks fleeted away in training and orientation
activities but the last few weeks had been unsettling for Mark. He was brought into Progressive at
a senior level in recognition of his prior experience in investment banking and a recent MBA degree
from a prestigious management school. Despite working hard, he had yet to come up with a
recommendation for a short sale. Diamond Foods, he thought, might be a good candidate for his
maiden recommendation.

It was an unnerving experience, however. Recommending a short sale could be risky because the
stock seemed to be on a tear. Diamond’s stock price had more than doubled in the previous year
(see Exhibit 1, Panel A for monthly stock price movements of Diamond’s stock vis-à-vis S&P 500
index during the previous year). On September 15, 2011, the Company announced impressive
growth of 63 percent in Earnings per Share (EPS) for the fiscal year ending July 31, 2011.
Within a week of that announcement, Diamond’s stock price increased from $78 to $90 (see
Exhibit 1, Panel B, for daily price movements of Diamond’s stock vis-à-vis S&P 500 index in the
days following the announcement).

The ‘Sell’ recommendation of Off Wall Street was striking because several analysts2 had not
changed their rating on the stock. These analysts included Sun Trust Robinson Humphreys’ William
Chappel who cut the price target from $90 to $75 but remained comfortable with Diamond’s
accounting for the “momentum” payments to walnut farmers (explained later in a separate section
of the case). Deutsche Bank reiterated a ‘Hold’ rating on Diamond citing their belief in the strategic
logic behind the Pringles® acquisition and management’s entrepreneurial approach to the snack
category. They set a price target of $76 based on an equal weighting between traditional multiples
and a discounted cash flow (DCF) model assuming growth of 4 percent in sales, 5 to 6 percent in
earnings before income tax, 8 to 10 percent in earnings per share growth, and a 9 percent WACC
(weighted average cost of capital). Northland Securities had recently upgraded Diamond, and
KeyBanc had raised the price target. Jim Cramer, an analyst at streetinsider.com continued to be
bullish on Diamond, noting that “its story is much bigger than the company’s current market cap.”

In light of the optimistic view of Diamond by several firms, issuing a ‘Sell’ recommendation was a
risky move for Mark. At the same time, not making that recommendation could be a missed
opportunity. Based on his research, and expertise in financial reporting (Mark had earned an
undergraduate degree with a major in accounting), he was convinced that the accounting of the
“momentum” payments indeed overstated Diamond’s profitability. Mark was also eager to apply
2
Diamond was followed by analysts from major brokerages including: Sun Trust Robinson Humphreys, BB&T
Capital Markets, Price Target Research, Keybanc Capital Markets, Sadif Investment Analytics, Craig Hallum Capital
Group LLC, Redchip Companies, Janney Capital Markets, Deutsche Bank, Datamonitor, Disclosure Insight, ICD
Research, New Constructs, LLC, Validea. Com, ValuEngine, Inc. and Wright Investors Services.
the concepts and tools from courses such as corporate strategy, financial statement analysis and
stock valuation that he had taken in his MBA program to make a convincing case for a ‘sell’
recommendation, if it was warranted.

Diamond: The Company and its Products

Diamond Foods - specializing in processing, marketing and distributing nuts and snack products - is
the largest walnut processor in the world. The Company’s annual reports indicate that its products
are distributed widely in over 60,000 retail locations in the United States and in over 100 countries.
During 2011, sales outside the United States accounted for approximately 30 percent of the net
sales of the Company. Diamond’s major processing and packaging plant is located in Stockton,
California. California accounts for virtually all of the U.S. walnut commercial production.
Diamond identified three separate product lines in fiscal 2011 (source: Diamond Foods, 2011
annual report):

Snack. The snack products are sold under the Emerald®, Pop Secret® and Kettle Brand® brands.
Emerald products include roasted, glazed and flavored nuts, trail mixes, seeds, dried fruit and
similar offerings packaged in innovative re-sealable containers. Microwave popcorn products are
offered in a variety of traditional flavors, as well as a “better-for-you” product offering featuring
100-calorie packs.

Culinary and Retail In-shell. The culinary nuts are sold under the Diamond of California® brand in
grocery store baking aisles as well as produce aisles and through mass merchandisers and club
stores. Culinary nuts are targeted to individuals who prepare meals or baked goods at home and
who value fresh, high-quality products. The Company also sells in-shell nuts under the Diamond of
California® brand, primarily during the winter holiday season.

Non-Retail. The non-retail nut business includes international markets and North American
ingredient customers such as the food processors, restaurants, bakeries and food service
companies and their suppliers. The institutional and industrial customers use Diamond’s standard
products to add flavor and enhance nutritional value and texture in their product offerings.
Evolution of the Company

Diamond began in 1912 as a member-owned agricultural cooperative association. After almost a

century, it broke out of its shell with a 2005 initial public offering (IPO) in which it issued over eight
million shares to its grower-members and six million shares to the public.

Soon after incorporation, the Company began a series of acquisitions under the leadership of its
Chief Executive Officer Michael J. Mendes. In May 2006, Diamond acquired Harmony® Foods’ plant
in Fishers, Indiana that produced trail mixes, dried fruits and other snacks. In its fiscal 2006 annual
report, Diamond described its business as follows:

We are a branded food company specializing in processing, marketing and distributing

culinary, in- shell and ingredient nuts and snack products. We intend to expand our existing
business, and to continue to introduce new higher-value branded products in our culinary and
snack businesses, including snack products marketed under our Emerald® and Harmony®
brand names.

In fiscal 2007, Diamond’s sales and profits grew, thanks to an expansive and integrated marketing
campaign to extend the brand awareness of Emerald. The campaign featured a Super Bowl ad
conveying the message that nuts are an excellent source of natural energy during the time of day
when people need it most. Although profits were up in fiscal 2007, operating cash flows were
adversely affected by acceleration in the timing of payments to growers.

In September 2008, Diamond acquired Pop Secret®, a brand of microwave popcorn products, for
$190 million cash from General Mills. This was Diamond’s first foray into the broader and more
profitable snack market. Pop Secret® was the second largest brand of microwave popcorn, behind
ConAgra’s Orville Redenbacher®. A larger footprint in the snack aisle provided opportunities to
Diamond for cross promotions and for leveraging with grocery buyers because the same buyer
would typically handle both popcorn and nuts. The transition to favorable product mix, growth in
sales from international and ingredient segments, cost efficiency initiatives and favorable input
costs resulted in higher gross margins in fiscal 2009.

In February 2010, Diamond acquired Kettle Brand® Chips, a premium potato chip company, for
$615 million cash from Lion Capital LLP, U.K. Kettle Brand® chips were made with delicious blends
of all natural seasonings and were cooked in small batches in pure, healthy oils. Potato chips
offered distributional efficiency in that potato chips were bulky but light and they complemented
well with heavy, but less bulky nuts on the trucks that transported Diamond’s products to
supermarkets. The acquisition of Kettle Brand® Chips gave Diamond not only a solid footprint in
the snack market, but also helped to reduce its effective tax rate because of the sizable income that
Kettle generated in foreign jurisdictions with tax rates lower than those in the U.S.

Diamond financed the acquisitions largely by long-term debt. In addition, it issued 5.2 million
shares of common stock at $37 per share in March 2010 and replaced its credit facility on February
25, 2010 with a new five-year $600 million secured credit facility with a syndicate of lenders. The
3
debt covenants of Diamond required a minimum interest coverage ratio of 3.9:1 through October
2012. The credit agreements also required Diamond to maintain a maximum consolidated leverage
ratio (defined as total long-term debt divided by EBITDA – Earnings Before Interest, Taxes,
Depreciation and Amortization) of 4.75:1 and that it decline annually to reach 3.25:1 by April 2014.

The acquisitions changed the nature of Diamond’s business over the years. In the annual report for
fiscal year end July 31, 2011, Diamond described its business as an “innovative packaged food
company focused on building, acquiring and energizing brands.” The share of different products and
channels in Diamond’s sales for fiscal 2006-11 is presented below:

Sales (in millions dollars) for Year ended July 31,

Product/Channel
2006 2007 2008 2009 2010 2011
Snack 40.7 79.6 88.6 188.9 321.4 553.2
Culinary and retail In-Shell 286.5 297.2 335.4 276.2 249.0 262.9
Total retail 327.2 376.8 424.0 465.1 570.4 816.1
International non-retail 62.4 69.1 48.0 68.9 69.2 119.0
North American Ingredient/Food Service and other 87.6 76.6 59.5 36.9 40.6 30.8

Total Non-retail 150.0 145.7 107.5 105.8 109.8 149.8

Total net sales 477.2 522.5 531.5 570.9 680.2 965.9

Source: 10-K's Diamond Foods, Inc.

Although growth through acquisitions and increased focus on snacks was an important strategic
intent of Diamond, walnut processing remained a core part of its operations. Sales of walnuts, and
other nuts and snacks, as a percentage of net sales were as follows:

3
The actual credit agreement for Diamond stipulated a minimum fixed-charge coverage ratio that was more
complicated than an interest coverage ratio. For purposes of this case, assume the covenants were based on a
traditional interest coverage ratio (Source: Diamond Foods, annual reports).
 Sales (in millions dollars) for Year ended July 31,
Product/Channel
2006 2007 2008 2009 2010 2011

Walnuts 67% 60% 60% 47% Break-down not provided

Other nuts 33% 40% 40% 53% Break-down not provided

Total retail 100% 100% 100% 100%

Source: Annual Reports, Diamond Foods

The acquisitions helped Diamond achieve impressive sales growth and profitability. Its sales more
than doubled from 2006 to 2011, and net income grew almost six-fold during the same period. The
reported EPS exceeded the consensus analyst estimate in most years. The balance sheets,
statements of operations and statements of cash flows of Diamond for fiscal years 2006 to 2011 are
presented in Exhibits 2(A), 2(B) and 2(C), respectively.

- Insert Exhibits 2(A), 2(B) and 2(C) about here -

The price of Diamond’s common stock reflected the Company’s superior financial performance and
its promising growth prospects. It went up from $17 (IPO price in July 2005) to $90 in September
4
2011, earning investors a compound annual return of 32 percent.

The Mavericks Behind Diamond’s Success – CEO Michael Mendes and CFO Steven Neil

Michael Mendes was the main force in converting Diamond from a cooperative into a corporation
and for making walnuts more mainstream as a healthy snack rather than just a baking ingredient.
He joined Diamond in 1991 as the Company’s Vice President of International Sales and Marketing.
In 1997, at the age of 33, he was promoted to be Diamond’s President and Chief Executive Officer
(CEO). He served on Diamond’s Board of Directors beginning in 2005 and was chairman of the
Board from January 2011. Mendes worked hard to change Diamond into a more entrepreneurial
and performance-driven organization.

Steven Neil, who served as an independent director on Diamond’s board since 2005, became the
Company’s Executive Vice President, Chief Financial and Administrative Officer in March 2008. He
was also responsible for operations, logistics, IT, treasury, grower relations, and purchasing.
4
At the end of fiscal years 2006, 2007, 2008, 2009, and 2010, Diamond’s stock was trading at $15.36, $16.43,
$24.32, $28.20, $44.54, and $71.59 per share, respectively.
For their contributions to Diamond’s success, the CEO and the CFO were handsomely rewarded.
Mendes’ compensation more than tripled from $1.1 million in fiscal 2004 to $3.8 million in 2009.
By fiscal year 2011, it doubled again to approximately $7.3 million. The compensation paid to Neil,
who became CFO in March 2008, was approximately eight times that of his predecessor CFO at the
time of Diamond’s conversion from a cooperative.

Consistent with the goal of becoming a performance-driven organization, the compensation of

Diamond’s senior management was tied to the Company’s success. Regulatory filings indicate that
over the period 2009 to 2011, Mendes received $4.1 million in annual bonuses and $2.6 million of
that was attributable to Diamond beating its EPS goals. The proxy statements of fiscal 2010 specify
that Diamond’s annual bonus incentives “were determined by both a corporate financial objective,
representing 60% of bonus potential, and individual objectives for each named executive officer,
representing 40% of bonus potential.”

Plans for a More Prosperous Future: Diamond’s Attempts to Acquire Pringles ®

Acquisitions helped Diamond increase sales and improve profitability. For instance, Diamond
gained over 350 basis points of market share to 26 percent in fiscal 2011. Following several smaller
acquisitions, the Company embarked upon an even more ambitious target, Pringles®, the largest
potato crisp brand in the world. With sales in over 140 countries and manufacturing operations in
the U.S., Europe and Asia, Pringles® had a combination of proprietary products, unique package
design and significant advertising investment. The acquisition of Pringles® from Procter and Gamble
would enable Diamond to gain greater merchandising and distribution influence, leverage its sales
and distribution infrastructure, and obtain a broader global manufacturing and supply chain
platform with access into key growth markets including Asia, Latin America and Central
Europe. Management viewed the Pringles® acquisition as a crown jewel that would make Diamond
5
the second largest snack food company in the world (only behind PepsiCo’s Frito-Lay®).

Beginning in May 2010, Diamond submitted several offers to Proctor and Gamble (P&G) to
purchase its Pringles® division. Although Proctor & Gamble initially rejected Diamond’s offers,
negotiations resumed in February 2011. On April 5, 2011, Diamond reached an agreement to
acquire Pringles®. In the conference call announcing the acquisition, Diamond’s CEO Michael
Mendes asserted that “Pringles® is a great strategic fit. In the same conference call, CFO Steven
Neil mentioned that although Diamond would incur merger and integration related costs of

5
Frito-Lay®, with $13 billion in annual sales accounted for nearly 62% of U.S. salty snack sales in 2011.
(http://www.pepsico.com/Download/Frito-Lay_Quick_Facts.pdf )
 6
approximately $100 million over the first two years, he agreed with Mendes that “the financial
benefits of improved margins, significant EPS accretion, and free cash flow will make Diamond an
even stronger company in the future, delivering exceptional value to Diamond and P&G
shareholders.” The news of Pringles® acquisition and prospects of resulting improvement in
financial performance propelled Diamond’s share price to $96.13 in September 2011.

In the form DEFM14A (definitive proxy statement relating to merger or acquisition) filed with the
SEC, Diamond noted that the synergies were expected to come from the efficiencies of combining
Diamond and Pringles®, and leveraging the current administrative, selling and marketing functions,
along with Diamond’s supply-chain and distribution network. To acquire Pringles®, Diamond would
issue 29,143,190 shares of Diamond common stock and assume newly issued Pringles® debt, for a
total estimated purchase price of 2.9 billion.

The Accounting Controversy: Recording of “Momentum” Payments

The sell recommendation of Off Wall Street stated that the “momentum” payment paid to walnut
growers in September 2011 (and expensed in fiscal year 2012) may have been in lieu of a
retrospective payment to compensate growers for the prior year’s crop. On the same day that the
Off Wall Street report came to his desk, Mark read an article in Reuters Breaking Views stating that
“Diamond’s long-term contracts gave 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.”

Mark delved into historical financial statements of Diamond to understand the accounting of
payments to walnut growers. A footnote on inventories from Diamond’s annual report for the fiscal
year ending July 31, 2011 stated:

We have entered into long-term Walnut Purchase Agreements with growers, under
which they deliver their entire walnut crop to us during the Fall harvest season and
we determine the minimum price for this inventory by March 31, or later, of the
following calendar year. The final price is determined no later than the end of the
Company’s fiscal year. This purchase price will be a price determined by us in good
faith, taking into account market conditions, crop size, quality, and nut varieties,
among other relevant factors.

6
On September 16, 2011, Diamond announced in its proxy statement an increase of $50 million in the estimated
transaction and integration costs of the Pringles® acquisition, raising the figure from $100 million to $150 million.
 th
When Mark woke up on the morning of September 27 , the thought of issuing a “sell”
recommendation on Diamond started hovering over him again. Over a cup of morning coffee, he
perused the Wall Street Journal and there it was; news of Diamond again. The WSJ story (Wall
Street Journal, September 27, 2011) specifically noted the momentum payment made to growers
on September 2, 2011 and reminded investors to take a closer look at Diamond’s historical
business – Walnuts – and accounting thereof:

As walnut prices surged for the 2010 crop, Diamond paid growers much less than
most buyers, according to several growers interviewed by the Wall Street Journal.
And yet on September 2, Diamond made an extra "momentum" payment to growers
they hadn't received in past years. The payment sizes varied, but averaged 25 cents a
pound or more, growers say.

The Company maintained, however, that the payment was for the current year (fiscal 2012) rather
than the prior period. In an e-mail response to the Wall Street Journal, Diamond said:

In an effort to optimize cash flow for growers, particularly in light of the delayed
harvest, we issued a “momentum” payment to growers that provide additional cash
flow in the fall consistent with the current market environment as we enter the 2011
harvest.

Materiality of the “momentum” payments

Mark wondered if the “momentum” payments had a real economic effect on Diamond or it was
just an accounting maneuver with little impact on the firm valuation because its cash flows were
unaffected. He also wondered whether the “momentum” payments were material. As for the
materiality, a story in the WSJ (September 27, 2011) mentioned:

That payment is critical to investors because it would have made a big dent in
Diamond's earnings had it been made by July 31, when the company's fiscal year
ended. The company declined to specify the size of the payment, but it's possible to
make a decent estimate. ... So conservatively assuming it bought 20% of 2010's
output, the “momentum” payments would total $50 million. That compares with
$93 million in operating income for the entire fiscal year.
The estimate of $50 million was lower than that reported in Breakingnews.com on the previous
day (September 26, 2011). It noted:

Based on Diamond’s estimated market share, the momentum payments make

the company’s costs around $60 million lower than they would be had
Diamond paid something closer to rivals.

More than the impact on the past profitability, Mark was concerned about the effect of
underpayments on the future profitability of Diamond. The Wall Street Journal news item
noted:

Even with the September payment, growers still look underpaid for the 2010
crop. Independent grower Ryan Palm, for example, says he received about 70
cents a pound before the momentum payment and less than $1 a pound if it's
8
included.

Pressure from growers could quickly become an issue for Diamond. After all,
growers can go elsewhere when contracts expire and exports to places like
China and Turkey have been surging.

Diamond’s independent auditors – Deloitte – who were also the auditors for P&G – did not
raise any red flags for Diamond’s accounting treatment of “momentum” payments. They
provided an unqualified audit opinion on Diamond’s financial statements stating that
Diamond (a) complied with GAAP and (b) maintained effective internal control over its
financial reporting.

The Critical Moment

Mark reviewed the Off Wall Street research report again. He noted the conclusion therein and
took copious notes of the supporting explanations in the report (Exhibit 3).

- Insert Exhibit 3 about here -

The time to make a decision, whatever it may be, had arrived. Waiting any longer would have
consequences that Mark was not comfortable with.
8
United States Department of Agriculture, in its Walnut Raisin Prune Report (issued at different dates)
reported the average walnut prices (cents per pound) as follows: 81.5 (2006), 114.5 (2007), 64 (2008), 85.5
(2009), 101.9 (2010) and 143.5 (2011).
 Requirements

Requirement 1
Profitability, Risk, and Cash Flow Analysis

(a) Prepare common-size statements of operations for the past five fiscal years (2007 – 2011)
and common-size balance sheets on the respective end of fiscal years for Diamond. Using
the common-size financial statements, describe important changes over the years (2007-
2011) in the financials of Diamond.

(b) The DuPont model disaggregates the performance of managers into three components
(profitability, asset utilization, and financial leverage) and encourages managers to focus on
both the balance sheet and the income statement. Apply the DuPont model to analyze
financial performance of Diamond during 2009-2011. What are the major reasons for the
changes in ROA and ROCE over this period (2009-2011)?

(c) Refer to the statements of cash flows provided in case exhibit 2(C). What are the likely
reasons for changes in Diamond’s cash position during 2006-2011?

(d) Has the short-term liquidity risk and long-term solvency risk of Diamond changed during
2007-2011? Is Diamond faced with the prospect of violating any of its debt covenants in
2011?

Requirement 2
Accounting Analysis of “Momentum” Payments

(a) Does Diamond’s recording of the “momentum” payments comply with the Generally
Accepted Accounting Principles (GAAP)? Why or why not?

(b) How does a careful analysis of published financial statements suggest that Diamond
recently engaged in unusual accounting practices?

(c) WSJ estimated that the pre-tax effect of “momentum” payments being recorded in a later
period was about $50 million. Breakingnews.com estimated the same to be around $60
million. Assume that the effect would be about $55 million pre-tax, the average of the
estimates from the two sources. Further, assume that approximately 88 percent of the
inventory purchased by Diamond is sold in the year of purchase, the remaining 12 percent
 being carried in inventory to the following fiscal year.

Assume that Mark concludes that the “momentum” payments made in September 2011
and expensed in fiscal year 2012 (ending on July 31, 2012) should instead have been
recorded as the cost of purchases of fiscal year 2011 (ending on July 31, 2011). He wants
you to evaluate the financial statement effects of correcting Diamond’s recording of
“momentum” payments on its financial statements of fiscal 2011. Present in a tabular form
the effect of the incorrect recording the “momentum” payment in fiscal 2011 on the
following items in the financial statements. Use Diamond’s effective tax rate in 2011 to
determine tax effects.

Overstated, Understated or No By how much (amount, in

Item
Effect? thousand dollars)?
Statement of Operations for the year ended 7/31/2011:
Cost of sales
Income from operations
Income before income taxes
Income taxes
Net income
Balance Sheet as at 7/31/2011:
Inventories
Deferred income taxes
Prepaid income taxes
Payable to growers
Retained earnings

(d) What is the effect of correcting the accounting misstatements for “momentum” payments
on the debt covenants of Diamond? Show computations.

(e) What were plausible motivations for Diamond’s management to misstate financial results?

References

Diamond Foods, Annual Reports, accessed at

http://investor.diamondfoods.com/phoenix.zhtml?c=189398&p=irol-sec

Off Wall Street, Report on Diamond Foods, 2011, accessed at:

http://www.offwallstreet.com/reports/NEW_DMND_9-25-11.pdf
Reuters, Breakingviews. 26 September 2011. Mixed Nuts, by Jeffrey Goldfarb.

Wall Street Journal, 27 September 2011, “Hidden Flaw in P&G’s Diamond Deal.”
Exhibit 1

Panel A
Monthly Stock Price Movements: Diamond Foods (DMND) and S&P 500 Index

Date DMND S&P 500 Index

9/1/2010 40.74 1141.20 90.00 1400.00

10/1/2010 43.98 1183.26

80.00 1350.00
11/1/2010 46.32 1180.55
70.00
1300.00
12/1/2010 52.91 1257.64
60.00
1250.00
1/3/2011 49.56 1286.12
50.00
2/1/2011 50.74 1327.22 1200.00
40.00
3/1/2011 55.57 1325.83 1150.00
30.00
4/1/2011 65.48 1363.61
1100.00
20.00
5/2/2011 74.23 1345.20
10.00 1050.00
6/1/2011 76.14 1320.64
0.00 1000.00
7/1/2011 71.44 1292.28

8/1/2011 78.70 1218.89

9/1/2011 85.09 1204.42 DMND S&P 500 Index

Panel B
Daily Stock Price Movements: Diamond Foods (DMND) and S&P 500 Index

Date DMND S&P 500 Index

9/14/2011 76.32 1188.68 100.00 1240.00

90.00 1220.00
9/15/2011 78.07 1209.11 80.00
1200.00
70.00
9/16/2011 87.12 1216.01 1180.00
60.00

9/19/2011 87.32 1204.09 50.00 1160.00

40.00 1140.00
9/20/2011 92.28 1202.09 30.00
1120.00
20.00
9/21/2011 91.72 1166.76 1100.00
10.00

0.00 1080.00
9/22/2011 90.95 1129.56
 9/23/2011 90.19 1136.43

DMND S&P 500 Index

9/26/2011 85.09 1162.95

Source: Yahoo Finance

 Exhibit 2(A)
Balance Sheet, July 31 (Amounts in thousand dollars)
2006 2007 2008 2009 2010 2011
ASSETS
Current assets:

Cash and cash equivalents 35,614 33,755 74,279 24,802 5,642 3,112

Trade receivables, net 49,536 50,662 46,256 33,492 65,553 98,218

Inventories 99,177 90,619 88,526 85,027 143,405 145,575

Deferred income taxes 4,578 4,805 7,387 13,109 10,497 13,249

Prepaid income taxes 3,147 1,854 - - 9,225 2,783

Property held for sale 1,728 - - - - -

Prepaid expenses and other current assets 4,182 2,417 4,261 3,594 5,767 13,102

Total current assets 197,962 184,112 220,709 160,024 240,089 276,039

Restricted cash - - - - 15,795

Property, plant and equipment, net 34,291 33,936 34,606 51,115 117,816 127,407

Deferred income taxes 4,812 4,922 5,802 6,230 13,625 3,870

Goodwill 5,077 5,432 5,432 76,076 396,788 407,587

Other intangible assets, net 3,941 3,707 3,473 97,883 449,018 450,855

Other long-term assets 6,949 4,294 3,245 3,564 8,536 6,842

Total assets 253,032 236,403 273,267 394,892 1,225,872 1,288,395

LIABILITIES AND STOCKHOLDERS EQUITY

Current liabilities:

Current portion of long-term debt - 162 - 15,000 40,000 41,700

Accounts payable and accrued liabilities 28,371 26,306 42,251 64,453 92,166 144,060

Payable to growers (Note 1) 81,902 57,117 56,942 29,149 35,755

Total current liabilities 110,273 83,585 99,193 108,602 167,921 185,760

Long-term obligations 20,000 20,345 20,204 100,085 516,100 490,001

Deferred income taxes - - - 1,221 144,755 131,870

Other liabilities 11,933 7,132 7,647 11,643 17,153 25,969

Stockholders equity:

Common stock, $0.001 par value 16 16 16 17 22 22

Treasury stock, at cost - (1,436) (3,203) (4,256) (5,050) (6,867)

Additional paid-in capital 93,962 101,106 112,550 122,817 307,032 318,083

Accumulated other comprehensive gain/(loss) (36) 2,233 1,584 (1,296) (869) 18,500

Retained earnings 16,884 23,422 35,276 56,059 78,808 125,057

Total stockholders equity 110,826 125,341 146,223 173,341 379,943 454,795

Total liabilities and stockholders equity 253,032 236,403 273,267 394,892 1,225,872 1,288,395

Source: 10-K reports of Diamond Foods filed with the SEC

Note 1: Payable to growers was presented in Diamond’s balance sheet as a separate line item until July
31, 2010. In the balance sheet of July 31, 2011, however, the payable to growers of $15,186 were
combined with accounts payable and accrued liabilities of $128,874, for a total of $144,060.
 Exhibit 2 (B)

Statements of Operations for the year ended July 31 (In thousand dollars, except per share amounts)

2006 2007 2008 2009 2010 2011

Net sales 477,205 522,585 531,492 570,940 680,162 965,922

Cost of sales 411,809 443,945 443,490 435,344 519,161 714,775

Gross profit 65,396 78,640 88,002 135,596 161,001 251,147

Operating expenses:

Selling, general and administrative 37,046 42,541 43,613 60,971 64,301 96,960

Advertising 17,977 20,445 20,508 28,785 32,962 44,415

Restructuring and other costs, net 3,442 (15) - - - -

Loss on termination of defined benefit plan - 3,054 - - - -

Acquisition and integration related expenses - - - - 11,508 16,792

Total operating expenses 58,465 66,025 64,121 89,756 108,771 158,167

Income from operations 6,931 12,615 23,881 45,840 52,230 92,980

Interest expense, net 295 1,291 1,040 6,255 10,180 23,840

Other 310 98 - 898 1,849 -

Income before income taxes 6,326 11,226 22,841 38,687 40,201 69,140

Income taxes (tax benefit) (1,010) 2,793 8,085 14,944 13,990 18,929

Net income (loss) 7,336 8,433 14,756 23,743 26,211 50,211

Earnings per share:

Basic 0.47 0.53 0.92 1.45 1.40 2.28

Diluted 0.47 0.53 0.91 1.42 1.36 2.22

Shares used to compute earnings per share:

Basic 15,634 15,786 16,088 16,073 18,313 21,577

Diluted 15,653 15,786 16,152 16,391 18,843 22,242

Total dividends on common stock: 1,407 1895 2,902 2,960 3,462 3,962

Annual dividend per share: 0.09 0.12 0.18 0.18 0.18 0.18

Source: 10-K reports of Diamond Foods filed with the SEC

 Exhibit 2 (C)
Statements of Cash Flows for the year ended July 31 (In thousand dollars)
2006 2007 2008 2009 2010 2011
CASH FLOWS FROM OPERATING ACTIVITIES
Net income 7,336 8,433 14,756 23,743 26,211 50,211
Adjustments:
Depreciation and amortization 5,532 7,561 6,420 11,362 17,154 29,465
Deferred income taxes (1,531) (1,874) (3,022) (2,800) 7,072 (7,534)
Loss termination of defined benefit plan - 2,575 - - - -
Tax benefit related to stock-based compensation plans - - - (1,067) (434) (2,274)
Stock-based compensation 3,992 5,859 6,893 3,901 3,231 6,974
Gain on sale of property held for sale - (1,193) - - - -
Other, net 395 56 4 858 1,109 1,055
Changes in assets and liabilities:
Trade receivables (4,805) (1,048) 4,406 12,764 (2,873) (32,665)
Inventories 17,278 8,077 2,093 10,316 (45,852) (2,170)
Prepaid expenses and income taxes and other current assets (1,957) 1,581 10 1,053 (6,437) (893)
Other assets 1,764 454 24 - - -
Accounts payable and accrued liabilities (4,419) (1,871) 15,475 (6,562) (5,462) 17,577
Other, net - - - (200) 4,693 5,921
Payable to growers 9,348 (24,785) (175) - - -
Other liabilities 1,027 (11) 192 - - -
Net cash provided by (used in) operating activities 33,960 3,814 47,076 53,368 (1,588) 65,667

CASH FLOWS FROM INVESTING ACTIVITIES:

Capital revolvement from CoBank 126 419 299 - - -
Net proceeds from sales of property, plant and equipment 49 2,941 12 - - -
Payment of Harmony acquisition costs (19,186) (197) - - - -
Purchases of property, plant and equipment (8,354) (6,790) (6,583) (7,994) (11,790) (27,703)
Net deposits of restricted cash - - - - - (15,795)
Acquisitions, net of cash acquired - - - (190,224) (615,389)
Other, net - - - 133 618 262
Net cash used in investing activities (27,365) (3,627) (6,272) (198,085) (626,561) (43,236)

CASH FLOWS FROM FINANCING ACTIVITIES:

Revolving line of credit borrowings - - - - 176,000 -
Repayment of revolving line of credit (2,119) (162) - (9,900) (4,800)
Net proceeds from issuance of long-term debt - - - 123,027 391,148 21,350
Payment to members of membership interest (17,329) - - - - -
Payment of long-term debt and notes payable - - - (30,141) (125,119) (40,884)
Gross proceeds from equity offering - - - - 179,737 -
Issuance of common stock under stock plans 802 1,204 3,972 - - -
Dividends paid (1,407) (1,895) (2,902) (2,960) (3,462) (3,962)
Excess tax benefit from stock option transactions 37 81 579 1,067 434 2,274
Other, net - - - 4,247 24 940
Purchase of treasury stock - (1,436) (1,767) - - -
Net cash (used in) provided by financing activities (20,016) (2,046) (280) 95,240 608,862 (25,082)

Effect of exchange rate changes on cash - - - - 127 121

Net increase (decrease) in cash and cash equivalents (13,421) (1,859) 40,524 (49,477) (19,160) (2,530)

Supplemental Disclosure of Cash Flow Information

Cash paid for:
Interest 696 1,638 1,183 5,989 9,088 21,998
Income taxes 2,178 3,878 5,945 19,438 11,113 8,751

Source: 10-K reports of Diamond Foods filed with the SEC

Conclusions: Exhibit 3
Excerpts from Off Wall Street Report on Diamond Foods

1. Diamond appears to be losing its dominant position in the walnut industry. As a result, its
business model is deteriorating and its profitability is under pressure.

2. Company profitability also appears to be overstated due to accounting treatment of a

prospective “momentum payment” paid to walnut growers in September of 2011, which may
be in lieu of a retrospective payment.

3. As purchase agreement with walnut suppliers signed at the time of the IPO expire, DMND
risks losing suppliers due to its practice of paying discounted walnut prices, or its cost of
goods sold will rise.

4. Integration risks inherent in Pringles® acquisition.

5. Earnings estimates appear to be too high. We estimate the company will earn non-GAAP EPS
of $2.75 in FY 2012 and $3.18 in FY 2013, which compared unfavorably to the “street’s”
estimates of $3.14 for FY 2012 and $3.73 for FY 2013.

6. On a P/E and EV/EBITDA basis, we think the shares might trade at about $43.

Supporting Arguments/Explanations:

By our account, pro-forma revenue CAGR would have been only about 3.6% if Pop Secret and Kettle
Foods had been acquired at the beginning of FY 2006.

With the company trading at 29X FY 2012 consensus EPS and 24X FY 2013 consensus EPS, we think
even small earnings misses should mean major downside for the shares. If we are correct in our
assessment of these “momentum” payments, the company conceivably might even be forced to
restate its FY 2011 financial statements and possibly report a revised EPS of only around $1.14.

With growing walnut demand, we hear that many buyers are now offering much quicker payments,
with some even paying up in advance of the harvest. Walnut demand is skyrocketing due to increased
consumption in the US, China, the Middle East, and Europe. Yet, Diamond appears to have continued
to treat its farmers as if they need Diamond more than Diamond needs the farmers.
We think there are numerous risks to the Pringles® transaction. Most importantly,
Diamond investors have been paying up for growth. Yet, Pringles is not a growth company.
Pringles® revenue was up 6% for its recently reported fiscal year on a volume increase of
7%. However, this was subsequent to easy comparisons from 2010, when Pringles®
revenues were down by 2% and volumes were down by 5%. And although we do not have
volume information for FY 2009, Pringles® revenue was down -9%, so volume was likely
down materially too. Comps should get more difficult and Pringles® annual revenue
growth is likely return to its long-term average of 2% to 3%.

Integrating the cultures of Diamond and Pringles® could be difficult, with Diamond’s
entrepreneurial environment possibly clashing with a more institutionalized Pringles’
management structure. Based on our analyses, it appears both Diamond as it exists today and
Pringles® are growing revenues in just low single digits on a pro forma basis over the long
term. As such, long term earnings growth will likely be unimpressive as well, and we think the
shares should trade at about a market multiple of 13X our FY 2013 EPS estimate, suggesting a
share value of about $41.

Assuming the Pringles® deal closes, the consolidated company will have about $1.3 billion of
debt outstanding. The deal will result in Diamond having about 52 million shares
outstanding, putting the total value of the company at about $6 billion, based on Diamond’s
current share price. The company’s guidance for EBITDA is $300-$310 million for FY 2012, so
the current enterprise value is about 20X EBITDA. We estimate EBITDA of $367 million for FY
2013, the first full year after Diamond acquires Pringles®, implying EV/EBITDA multiples of
16.3X. As the company misses “street” earnings estimates, we think maintaining a 10X
multiple might prove very difficult. At 10X our estimated FY 2013 EBITDA, the shares should
trade at about $45. We recommend investors sell Diamond shares with a target of $43, the
midpoint between our two valuation methods.

Source: Off Wall Street Consulting Group, Inc. Report on Diamond Foods dated 9/25/2011
Available at: http://www.offwallstreet.com/reports/NEW_DMND_9-25-11.pdf