Diamond Foods (Nasdaq:DMND) is trying to get back on solid footing after a series of self-inflicted wounds threatened the survival (or at least the independence) of the company not so long ago. While rehashing the company's accounting issues and strategic missteps is beyond the scope of this article, the fact remains that Diamond Foods is still in the middle of its clean-up operations. Valuing these shares is tricky given all the factors at work, but they do appear undervalued provided that the company can continue to repair its margins and clean up its capital structure.

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A Tough Quarter Comes In A Little Better Than Feared
It would be hard to call Diamond's fiscal third quarter a strong result, but it was better than most analysts expected. Revenue fell 11%, which was actually better than the 15% decline reflected in the averaging of sell-side estimates. Snack revenue improved almost 2% despite a nearly 6% decline in volume, while the nut business saw revenue contract 23% on a very large volume decline (40%) tied to deliberate SKU reductions.

As the SKU reduction in nuts is motivated at least in part by eliminating unprofitable products, the margin improvement in the quarter was a positive development. Gross margin improved by almost seven points overall, with almost eight points of improvement in snacks and a two and a half point improvement in nuts. It's worth noting, though, that nut gross margin is still less than one-quarter that of the snacks business. Diamond reported a modest operating loss for the quarter and would have nearly broken even without a warrant liability expense recognition.

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Still Running The Business, And That Keeps The Window Of Opportunity Open
One of the things I find interesting and encouraging about Diamond Foods is that the company remains committed to running this business along relatively sound business principles even with the remaining uncertainties of the turnaround effort.

When companies get into trouble, they often cut back on advertising and product support, which has the long-term consequence of choking revenue growth. Diamond is continuing to support its brands, though, and while the nearly 6% volume decline this quarter in snacks was not great, the company is still staying in the game from a market share perspective.

It's also important to remember that Diamond competes with some strong rivals that hold significant share in their respective markets. PepsiCo (NYSE:PEP) holds very significant share in the chips market, while ConAgra (NYSE:CAG) controls a large portion of the popcorn market. While there have been some shifts in volume market share, Diamond's dollar market share is doing alright, which is consistent with management pursuing more of a premium positioning for many of its snack products. Given the emphasis that others including Kellogg (NYSE:K), Mondelez (Nasdaq:MDLZ), and Campbell Soup (NYSE:CPB) have placed on growing their snack business, though, Diamond cannot afford to let up and that could represent some downside to operating margin leverage in the near term.

A Solid Hire For The CFO Position, But Ample Uncertainties Remain
Diamond Foods shareholders should be pleased with the company's hiring of Raymond Silcock as CFO of the company. Mr. Silcock has significant experience in the food industry, and would seem to have a particularly strong record with turnaround situations that ultimately end in the sale of the business.

Whether or not Diamond is thinking about a potential long-term sales transaction, there's plenty to do in the short term. The company still needs to improve its nut-buying operations, as well as complete the SKU restructuring in nuts. Diamond will also eventually have to do something about its capital structure and balance sheet – management chose not to refinance its $225 million loan from Oaktree Capital (which carries a 12% coupon) due to a lack of shareholder-friendly options, but finding a good solution here is important as this represents pretty expensive capital.

The Bottom Line
If Diamond can work through this turnaround and resolve its issues with the SEC and shareholder litigation, there is a pretty good collection of snack food brands to consider. While I would not advocate buying these shares with an eye towards an eventual takeover, I would acknowledge that plenty of packaged food companies are shopping for brands these days.

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Valuing Diamond Foods right now is quite tricky. The large net debt position virtually wipes out the company's long-term cash flow-based value, and EBITDA is likewise too depressed right now for EV/EBITDA to be helpful. EV/sales does suggest value here relative to other snack food companies like Lance (Nasdaq:LNCE) and more direct rivals like ConAgra. By no means do I think Diamond Foods should trade at parity with its peer group, but I do believe these shares are undervalued relative to the progress that management has made in turning around the business.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.