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Why Does This Hedge Fund Think Diamond Foods is Set for a Turnaround?

In a 13G filing yesterday, Litespeed Management LLC announced it had increased its stake in the snack food company Diamond Foods, Inc. (NASDAQ:DMND) by 25%, bringing their total ownership to 1.7 million shares—equaling 7.7% of Diamond Foods’ outstanding shares. Litespeed first took its initial position of 1.4 million shares during the second quarter. Managed by Jamie Zimmerman, Litespeed is an event-driven hedge fund focusing on special situations and distressed securities. The firm has around $1 billion of AUM. See all of her 13F holdings here.

02 Jamie Zimmerman

Various questions surrounding Diamond’s accounting has sent its stock tumbling over the past year. The accounting scandal cost Diamond Foods the Pringles acquisition, and led to the resignation of its CEO and CFO. Now the company appears to be a turnaround play.

The company lost around 70% of its value from in the final quarter of last year. Diamond’s stock price got a glimmer of hope in late December on news that David Einhorn might be an investor, no such luck—as Einhorn turned out to be short the stock. Diamond then saw a huge down week in February, losing more than 40% of its value—read more about the horrible week.

In early 2011, Diamond had announced plans to acquire Procter & Gamble Company (NYSE:PG)’s Pringles brand for $2.4 billion. Less than a year later, as the accounting scandal was in full swing, the company pulled out of the Pringles acquisition. At the time, the Pringles acquisition would have put Diamond Foods as the second largest snack food company in the world. A few months later Kellogg Company (NYSE:K) bought Pringles for $2.7 billion.

The Pringles acquisition by Kellogg should give the company the ability to access to international markets. Kellogg, the operator of Cheez-It, Keebler and Frosted Flakes, has seen commodity costs and demand softness cut into its 2Q profit, with the company reporting earnings down 10% from last year. However, the company maintains full year guidance on the back of optimism for its newly acquired Pringles brand. For 2Q, the company reported EPS of $0.84, versus $0.94 a year ago. Guidance for 2012 remained at $3.18-$3.30, with consensus estimates at $3.30. The company bought Pringles hoping to gain more international exposure and could use the help—Kellogg saw its U.S. segment revenues increase by 5.9% last quarter, but its international market sales fall by 3.8%.

On the other side of the transaction, P&G is up almost 10% since closing the selloff of its Pringles brand. P&G reported last quarter sales of $20.2 billion, slightly below estimates, with the primary drive being flat volume. EPS came in at $0.82, the equal to the same quarter last year, but $0.05 above consensus. However, P&G’s growth may be hampered due to its limited exposure to faster-growing emerging markets—under 40% of sales. The company does pay a solid dividend yield at 3.3%.

A couple of Diamond’s key competitors include The Hershey Company (NYSE:HSY) and Snyder S Lance Inc (NASDAQ:LNCE). Snyder recently announced an agreement to purchase Snack Factory, LLC for $340 million. Snack Factory is expected to add $0.02 to EPS in 2012 and $0.10 in 2013. The deal should help grow their top-line, which is expected to be up 8% next year. As well, EPS is expected to grow 35% this year from last year. The company recently posted EPS for last quarter that beat estimates by 5%.

Hershey’s EPS is expected to come in at $3.21 for 2012, versus $2.82 in 2011. As well, 2013 EPS is expected to be $3.48. Hershey recently acquired Brookside Foods Ltd.—a confectionery company—that should add $90 million in revenue to Hershey’s top-line in 2012. The Kraft purchase of Cadbury PLC in 2010 continues to put competitive pressures on Hershey’s candy business, namely internationally, but the company continues to meet estimates and is expected to grow EPS 15% this year versus 2011. Even with rising commodity costs, both Snyder and Hershey are up over 10% year to date.

Other notable investors in Diamond Foods at the end of 2Q were Ken Fisher, who upped his 1Q stake by 39%, and Rivanna Partners took a new position in the company that made up 5.5% of their 13F portfolio. It appears that Litespeed feels the Diamond Foods selloff due to the controversy over accounting issues—including payments to walnut growers that led to misguided inventory, income and cash flow numbers—may be overdone, making the company appealing from a valuation standpoint.

We must admit that the company does appear very cheap on a valuation basis—trading at a P/E of only 9 versus the average P/E of the peers listed of 23 (HSY 24x, LNCE 31x, PG 22x, K 16x). Diamond is expected to continue its strong growth—with next year revenues expected to grow by 13%, and 5-year EPS growth to average 15%. For investors considering a turnaround play, Diamond may be worth a look—the company is also trading at a 1.07 PEG, making it decidedly attractive.

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