COMMENT: Kettle buy a long-term jewel for Diamond
Two-thirds of Diamond's sales to come from brands after Kettle buy
Shares in Diamond Foods plummeted on Friday (26 February) in the wake of news that the US snack maker had struck a deal to acquire premium chip company Kettle Foods. However, investor-jitters aside, Katy Humphries suggests the long-term upside of the deal is likely to outweigh the short-term risks.
At the end of last week, Diamond Foods made two rather upbeat announcements.
The company detailed a 43% surge in net income during its fiscal second quarter. The group also beat off rumoured competition from the likes of PepsiCo and United Biscuits to acquire posh crisp maker Kettle Foods for US$615m.
The result was a rather sharp – and perhaps surprising – drop in the group's share price, which had increased an impressive 69% over the past 12 months. Shares in Diamond Foods plummeted 10%, or $3.86, on Friday to close at $34.85.
According to Diamond, the addition of Kettle would add more than $250m in revenues on a pro-forma basis, more than double the size of its snacks business and almost double Diamond’s EBITDA. The company said it expects the deal to add to earnings in fiscal 2011.
However, this rosy outlook did little to calm the nerves of investors over the high price tag – which is ten times Kettle's EBITDA - and how the deal will be funded.
The acquisition, almost equal to the company's current market capitalisation of around $645m, will be financed through a new, five-year $600m credit facility, an equity offering and available cash, Diamond said.
The US nut group today detailed the scale of its stock offering, which will see Diamond issue 4.5m new shares, with an additional 675,000 for potential over-allotments. The company will likely raise in the region of $160m from the offering.
The share issue is equivalent to about one-quarter of Diamond's existing outstanding shares and has the potential to dilute EPS.
However, Diamond has moved to quell this concern and, in its second-quarter earnings release, management forecast EPS in a range of $2.25–$2.35 in fiscal 2011, which begins in August.
Kettle is expected to contribute to Diamond's EPS in the range of mid-single digit to low-double digits in FY2011, the company added.
In addition to the new shares, Diamond will drastically increase its debt to earnings ratio from the current level of one times EBITDA to around four times EBITDA.
Although this heightened debt level certainly remains manageable – and below the magic 5x when debt levels are usually considered 'high' – Diamond's weakened balance sheet and its increasingly leveraged position will likely result in higher borrowing costs and increased risk for investors.
So, while having an expanded shareholder base or higher debt levels are not necessarily 'bad' developments for Diamond, the crucial question becomes what return Diamond can secure on its initial investment (and the ongoing cost of funding it).
The acquisition of Kettle will increase Diamond's revenue by 40% and almost double EBITDA. However, Diamond's ability to manage the Kettle brand going forward will be a key factor in whether the deal is judged a success.
According to BB&T Capital Markets analysts Heather Jones and Brett Hundley, this could represent a cause for concern.
“Half of its earnings will be derived from a category in which it has no background; this implies meaningful integration risk,” the analysts warn in a note to investors.
In addition, Jones and Hundley emphasise, the move into the crisp category will also bring it up against a new set of competitors – including the might of PepsiCo's Frito-Lay.
“Its new competitive set includes Frito-Lay, arguably one of the most capable and possibly the most aggressive competitor in the food-at-home space,” they caution.
Nevertheless, it is perhaps worth remembering here that Diamond's management has made a considerable success of its recent acquisition of Pop Secret.
The group acquired the Pop Secret microwave popcorn business from General Mills in 2008 for $190m.
As with Kettle, Diamond had no experience of the popcorn category.
As with Kettle, the popcorn brand has a similar consumer profile to Diamond's Emerald nut brand – providing cross promotional opportunities and increasing the dollar impact and cost effectiveness of marketing.
And, because popcorn, nuts and crisps often typically occupy adjacent shelf-space, both acquisitions have increased – or could increase – Diamond's relevance in the snack category, enhancing the company's ability to serve its retail customers.
Diamond has also indicated it will retain Kettle's existing management team, which will provide the company with not-inconsiderable experience of competing effectively in the chip category and mitigating some of the risks associated with Diamond's rawness in this category.
Announcing the acquisition, Diamond highlighted the strength of the Kettle brand, its move into premium snacking and the increased size of addressable market, which it said would grow by $9bn.
However, arguably the most significant impact that the acquisition will have on Diamond is that it would further its strategic goal of expanding its branded snack business.
Diamond operates two business units: its consumer snacks business and a culinary nut business.
While management has looked to increase profitability at the latter – providing a stable base for growth – the group has focused on expanding its higher-margin consumer snacks business in recent years.
In 2005, consumer retail accounted for 49% of sales, by 2009 this figure had increased to over 80% of sales.
The addition of Kettle would clearly further boost this strategic shift, meaning that more than two-thirds of revenue will come from the branded snacks business – a far cry from its beginnings as agricultural cooperative, Diamond Walnut Growers.
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