Is Diamond Foods the Next WorldCom?

When a high-growth stock losses momentum, the impact can be quick and severe. But when you add accounting questions — which require restatements — into the equation, the consequences can be devastating.
This certainly has been the case with Diamond Foods (NASDAQ:DMND[1]). During the past week, the company has placed its CEO, Michael Mendes, on administrative leave[2], as well as the CFO, Steven J. Neil. And the company will have to restate its financials for 2010 and 2011. As a result, Diamond’s stock price has plunged almost 40% over the past week.
Both the Securities[3] and Exchange Commission and the Justice Department are investigating the situation. It looks like Diamond pushed $80 million in payments — which were owed to its walnut growers in 2010 and 2011 — to a later year. At the same time, the company’s $2.35 billion acquisition of Proctor & Gamble‘s (NYSE:PG[4]) Pringles might have been a creative attempt to hide things — Diamond could have taken one-time charges for the merger expenses.
Now, it looks inevitable that the deal will not go through. P&G should have a rock-solid agreement that the accounting shenanigans were a violation of the merger agreement. It’s certainly bad stuff for Diamond Foods — but not necessarily lethal. If what has been disclosed is the extent of the fraud, then Diamond Foods should survive. If anything, DMND stock could end up being a bargain for investors.
But the larger problem is that accounting scandals often are the result of a growth-at-all costs culture.
A recent article[5] in The Wall Street Journal points out that Mendes had big ambitions for his company. He aggressively bought various companies, such as Pop Secret, and even spent millions on Super Bowl advertising and the Emerald Bowl sponsorship. Because of his move into premium-branded products, he had to compete against snack food rivals like ConAgra(NYSE:CAG[6]) and Kraft (NYSE:KFT[7]), which have the scale to spend huge sums on marketing.
But when the growth mentality becomes obsessive, it can mean that a company’s organization takes reckless risks — which could lead to a culture that allows for quick solutions and even fraudulent behavior.
There are many previous examples of this. One case is the former HealthSouth (NYSE:HLS[8]) CEO Richard Scrushy. During the 1990s, he pursued an hyperactive acquisitions strategy that created a multibillion-dollar company. But the dealmaking also proved to be an effective way to hide certain expenses. By 2003, the empire crumbled, and Scrushy eventually was convicted of crimes including money laundering and obstruction of justice. A civil court also ordered him to pay $2.87 billion in restitution.
Then there was the case of Bernie Ebbers, who created WorldCom. He was addicted to M&A, which helped to spur his need for growth. He tried to pump up earnings with accounting manipulations, but it was not enough. The company eventually went bust. As for Ebbers, he is now serving a 25-year prison term.
Again, in the case of Diamond Foods, the charges might be isolated to those already disclosed. But if history is any guide, more accounting issues could be waiting to be discovered — especially if the company had a “cult of CEO” environment.
Investors looking to make a value play on the company should stay away for now.
By Tom Taulli | February 14, 2012 2:45 pm