Is Diamond Foods a Classic Case of Accounting Fraud?

Diamond Foods DMND is a food company that manufactures and distributes snack products internationally. Recently, the producer came under fire for delaying its quarterly SEC filing in order to sort out possible accounting distortions.

Interestingly, the company's internal audit committee is spearheading the operation, looking for evidence that Diamond may have improperly booked costs in order to overstate income figures. Is Diamond Foods trying to use similar tactics as Enron did in 2001?

The news made investors very skittish, and brought the stock down over 20% in today's trading session.

What could investors expect if the company did in fact transfer expenses to the current year? The Diamond Foods audit committee is investing something called momentum payments. Essentially, investors believe that Diamond Foods used momentum payments to defer payments to walnut growers - on the books, at least, the payments were actually made in real life. As such, if the momentum payments are used in this manner, that means that the current fiscal year would have added costs associated with it, essentially understating real revenues.

Diamond Foods may have actually made the right move in transferring costs. While it is illegal, Diamond's annual statements show a slow 2010. 2011 was fine for the company, achieving huge revenues and controlling costs to nearly double net income. 2010, however, came close to being a worse year than 2009. As such, it makes sense why management would have wanted to do anything to cut costs on its books to somehow increase its net income.

Unfortunately, the momentum payments were not enough for the company. EPS ended up being lower in 2010 than in 2009, which is probably a result of increased equity issuances. In the grand scheme of things, Diamond Foods' stock did not underperform in 2010 by any definition. The company could have probably recorded the costs during the appropriate reporting periods and may have still experienced similar stock movement.

Now, however, Diamond Foods has to face embarrassment as well as possible litigation for accounting fraud. While it has not perpetrated a scheme as devastating as Enron's stock fraud in 2001, Diamond Foods may have initiated a long-term downwards trend. Once investors lose faith in a stock or a company's management team, the price is drastically affected, often for long periods of time. Unfortunately, while Diamond Foods attempted to save a few percentage points in 2010, it may have caused much more severe damage in 2011 due to improper accounting standards.

Diamond Foods is a bastion in the American food industry. It is currently in contention for purchasing the Pringles brand from Procter & Gamble PG, signaling some faith in the company's strength. After its internal audit committee is finished investigating 2010's accounting activity, further investigations may sprout. Litigation is possible, and shareholders may be permanently damaged from the news.

Diamond Foods is currently trading at about $30.75, down over 42% for the year.

ACTION ITEMS:

Bullish View:
Traders who believe that Diamond Foods did not perpetrate accounting fraud might want to consider the following trades:

• Long Diamond Foods by purchasing shares or call options. Diamond currently appears to be close to a technical support level, so now may be a good time to buy, especially since it fell off a cliff due to the news.

• Short another similar company, like Inventure Foods SNAK. You could short this company to hedge a long DMND trade or to accentuate your belief that Diamond will continue to dominate the snack food market.

• Long an ETF like the Consumer Discretionary SPDR XLY. If a significant industry like snack foods is doing well, consumer discretionary itself will probably do well.

Bearish View:
Traders who believe that Diamond Foods intentionally perpetrated accounting fraud may consider the following positions:

• Short Diamond after it breaches the $29.50 level, which appears to be a technical support level. The next support level appears to be at about $27.

• Long a competitor like Snyder S Lance LNCE, as someone bearish on Diamond may believe that a large-cap competitor is more likely to garner market share.

• Buy put options as Diamond Foods' earnings announcement comes along. The company may not be able to sustain its costs as precious metals rallied significantly in Q3 2011.

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