Warning: Diamond Foods Restatements May Contain Nutty Accounting

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In May, Diamond Foods was able to lower its bank debt load by taking a $225 million loan with distressed debt specialist Oaktree Capital. While some initially saw Oaktree as a so-called 'white knight,' a closer look at the terms of the deal indicates shareholders may face further downside were Diamond Foods earnings to be hit hard by restatements.

Oaktree Capital gave Diamond Foods a $225 million loan at a 12% annual interest rate that expires in 2020 and can be paid-in-kind during its first two years. Oaktree may also get warrants to buy roughly 4.4 million Diamond Foods shares, or 16.4% of the company's outstanding shares, at a price of $10 a share - roughly half the company's share price as of Tuesday's close.

With the apparent risk of delisting out of the way, even after Diamond Foods missed a series of Nasdaq earnings guidelines and cancelled its July 31 annual shareholder meeting, Jefferies analyst Thilo Wrede - one of the few analysts maintaining coverage on Diamond Foods -- details eight things to watch for in the earnings data dump expected after the market close on Wednesday.

Of most concern will be whether restatements will be in line with initial disclosures made by Diamond Foods's board in February, or if the company's accounting issues will escalate. Were restatements to be greater than commentary suggests it could open up a series of questions for investors.

According to Wrede of Jefferies, the most pressing question for the company is whether restatements are limited to Diamond Foods grower payments. Already, Diamond Foods has indicated it will have to increase its 2011 costs of goods sold by $40 million and 2010 figures by $20 million. "If there are more restatements than just those reflecting the grower payments, what are they and what caused them?," writes Wrede, in a Tuesday note sent to clients.

Diamond Foods should also have a detailed explanation of the root cause of its accounting issues, according to Wrede.

"Diamond Foods has limited its explanation of the cause of the restatements to a "breakdown of internal controls. We are looking for a more complete explanation of what went wrong and what steps have been put into place to ensure such a breakdown does not recur," Wrede adds.

Wrede also wants to see disclosure on when Diamond Foods will report fourth quarter 2012 earnings and those for the first quarter of 2013, with his understanding that the company has to file results by mid-December.

Given Diamond Foods complicated recapitalization agreement with Oaktree Capital, Wrede notes it's still uncertain whether the company will be able to cancel stock warrants at $10 a share due to Oaktree, and convert $75 million in debt to preferred stock carrying a 10% dividend. To not dilute shareholders by way of a warrant exercise at depressed price, Diamond will need to secure $125 million pounds of walnuts by year-end within a gross profit target of $54.4 million and a 14.9% gross margin.