| Diamond Foods Inc Item 1A RISK FACTORS This report contains forward-looking statements that involve risks and uncertainties |
| Our actual results may differ materially from the results discussed or implied in such forward-looking statements due to such risks and uncertainties |
| Factors that may cause such a difference include, but are not limited to, those discussed below, in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report |
| We could be required to conduct product recalls; concerns with the safety and quality of food products could harm our sales or cause consumers to avoid our products |
| We face risks associated with product liability claims and product recalls if our products cause injury, or become adulterated, mislabeled or misbranded |
| Our products are subject to product tampering, and to contamination risks, such as mold, bacteria, insects and other pests, shell fragments, cross-contamination and off-flavor contamination |
| If any of our products were to be tampered with, or become tainted in any of these respects and we were unable to detect this prior to shipment, our products could be subject to a recall |
| Our ability to sell products could be reduced if governmental agencies conclude that our products have been tampered with, or that certain pesticides, herbicides or other chemicals used by growers have left harmful residues on portions of the crop or that the crop has been contaminated by aflatoxin or other agents |
| A significant product recall could cause our products to be unavailable for a period of time and reduce our sales |
| Adverse publicity could result in a loss of consumer confidence in our products and also reduce our sales |
| Product liability claims and product recalls could increase our expenses and have a material adverse effect on demand for our products and, consequently, reduce our sales, net income and liquidity |
| Our raw materials are subject to fluctuations in availability and price |
| The availability, size, quality and cost of raw materials for the production of our products, including walnuts, pecans, peanuts, cashews, almonds and other nuts, are subject to risks inherent to farming, such as crop size, quality, and yield fluctuations caused by poor weather and growing conditions, pest and disease problems, and other factors beyond our control |
| Nut market prices fluctuate based on supply and demand |
| Worldwide demand for nuts has been increasing, and if the supply of nuts does not expand to meet demand, our costs will increase |
| Supply shortages and resulting price increases could adversely impact our profitability |
| High prices might dampen growth of consumer demand for nuts |
| Currently, we do not hedge against changes in nut commodity prices |
| Because walnuts currently represent approximately 65prca of our gross sales, we are particularly vulnerable to crop disasters or other events that could cause significant fluctuations in the availability and cost of walnuts |
| We receive our walnut crop each Fall, and process and sell the crop over the next 12 to 15 months |
| We start each Fall with a large inventory of walnuts, which diminishes as we process and sell the crop |
| If there is a decline in the market price of walnuts, a significant portion of our inventories could decline in value, and this might result in a write-down of inventory |
| Our inventories of other nuts are also substantial |
| Any write-down of inventory would adversely impact our operating results |
| We face intense competition from national and regional competitors and snack food industry competitors that could negatively affect our results of operations |
| We operate in a highly competitive environment |
| In general, competition in our markets is based on product quality, price, brand recognition, and brand loyalty |
| Our products compete against food and snack products sold by many regional and national companies, some of which are substantially larger and have greater resources |
| We also compete for shelf space in retail grocery, convenience, drug, mass merchandiser, and club stores |
| As these retailers consolidate, the number of customers and potential customers declines and the purchasing power of the consolidated retailers increases |
| As a result, there is also greater pressure to manage distribution capabilities in ways that increase efficiency for these large retailers, especially on a national scale |
| Our competitors with greater resources may be in a better position to meet these requirements |
| If we cannot improve our national distribution capabilities, we might not be able to compete effectively and our sales may decline |
| 8 _________________________________________________________________ [57]Table of Contents With the launch of our Emerald brand snack product line, we entered the highly competitive snack food industry |
| Some channels through which we sell our Emerald products, such as drug and convenience stores, are different than those that we typically use for culinary and in-shell products, and we have less experience in these channels than our competitors |
| Our principal competitors in the snack industry have substantial financial, marketing and other resources |
| If our competitors lower their prices or increase their promotional spending, or we are unable to compete effectively, our growth opportunities, margins and profitability may decline |
| Sales to our top customer represented approximately 20prca of our net sales |
| The loss of any major customer could adversely impact our business |
| We depend on a few significant customers for a large proportion of our net sales |
| This concentration has become more pronounced with the trend toward consolidation in the retail grocery store industry |
| Sales to SAM’s Club and Wal-Mart represented approximately 19prca of total net sales for the year ended July 31, 2006 |
| The loss of a significant customer or a material decrease in purchases could result in decreased sales and adversely impact our net income |
| Because we experience seasonal fluctuations in our sales, our quarterly results will fluctuate and our annual performance will depend largely on results from two quarters |
| Our business is highly seasonal, reflecting the general pattern of peak consumer demand for nut products during the months of September, October, November, and December |
| Typically, a substantial portion of our revenues are earned during our first and second fiscal quarters |
| We generally experience lower revenues during our third and fourth fiscal quarters and in the future may incur losses in these quarters |
| Sales in the first and second fiscal quarters accounted for approximately 63dtta3prca of our revenues for the year ended July 31, 2006 |
| If sales in these quarters are lower than expected, our operating results would be adversely affected, and it would have a disproportionately large impact on our annual operating results |
| Changes in the food industry, including changing dietary trends and consumer preferences, could reduce demand for our products |
| Consumer tastes can change rapidly due to many factors, including shifting consumer preferences, dietary trends, and purchasing patterns |
| Our growth is largely dependent on the snack industry, where consumer preferences are particularly unpredictable |
| If we fail to anticipate, identify or react to these changes, demand for our products could decline, which would in turn cause our revenue and profitability to be lower |
| Developments in the walnut industry could threaten our position in the industry |
| Advances in walnut shelling and processing equipment have recently made it possible for large growers with consistent supplies of easy-to-crack varieties of walnuts to shell their own walnuts and compete directly with us in the ingredient products segment |
| In order to compete effectively in the ingredient market, we will need to develop strategies for responding to these market developments |
| If we are unable to respond effectively to this change, our sales and profits could be impaired |
| We depend on our key personnel and if we lose the services of any of these individuals, or fail to attract and retain additional key personnel, we will not be able to implement our business strategy or operate our business effectively |
| Our future success largely depends on the contributions of our senior operating management team |
| We believe that the expertise and knowledge of these individuals about our industry, and their respective fields, are critical factors to our continued growth and success |
| The loss of the services of any of these individuals could have a material adverse effect on our business and prospects |
| Our success also depends upon our ability to attract and retain additional qualified marketing, technical, and other personnel |
| The Public Health Security and Bioterrorism Preparedness and Response Act of 2002, which we refer to as the Bioterrorism Act, includes a number of provisions designed to help guard against the threat of bioterrorism, including new authority for the Secretary of Health and Human Services to take action to protect the nation’s food 9 _________________________________________________________________ [58]Table of Contents supply against the threat of intentional contamination |
| The US Food and Drug Administration, or FDA, is responsible for developing and implementing these food safety measures |
| The FDA has been in the process of issuing new rules, and the uncertainty of the content of these rules makes it difficult for us to predict what impact they might have on our business |
| The potential actions that may be taken by the federal government under the Bioterrorism Act and related rules may have a material adverse effect on our business by limiting our supply of or increasing prices for cashews and other imported nuts |
| In addition, the Bioterrorism Act and related rules may also result in higher costs for plant security and product safety, and create additional costs associated with the new regulatory requirements |
| If we are unable to pass these higher costs on to our customers, our results of operations and financial condition may be adversely affected |
| Government regulation could increase our costs of production and increase our legal and regulatory expenditures |
| We are subject to extensive regulation by government agencies |
| Among other things, these regulations govern the manufacturing, importation, processing, packaging, storage, distribution, and labeling of our products |
| We are also subject to environmental regulations governing the discharge of air emissions, water and food waste, and the generation, handling, storage, transportation, treatment and disposal of waste materials |
| New or amended statutes and regulations, increased production at our existing facilities, and our expansion into new operations and jurisdictions may require us to obtain new licenses and permits and could require us to change our methods of operations at costs that could be substantial |
| For example, we currently fumigate walnuts with methyl bromide to control pest infestations during the transport and storage of walnuts |
| A recent amendment to the Clean Air Act requires the use of methyl bromide for pest control to be phased out |
| We have obtained a temporary exemption from the phase out of methyl bromide, but we may not be able to maintain the exemption in the future |
| The currently available alternatives to methyl bromide are more expensive than methyl bromide and are less effective at controlling pest infestations |
| As a result, if we are unable to continue to use methyl bromide, our costs would increase, shipments of our products could be delayed and we may suffer pest infestations that could harm the nuts we use in our products |
| Failure to comply with applicable laws and regulations could subject us to civil remedies, including fines, injunctions, recalls or seizures, as well as possible criminal sanctions, all of which could have a material adverse effect on our business |
| We are subject to risks of doing business internationally |
| We conduct a substantial amount of business with vendors and customers located outside the United States |
| During 2006, sales outside the United States, primarily in Germany, Japan, Spain and Italy, accounted for approximately 28prca of our net sales |
| Our international operations are subject to a number of inherent risks, including: • local economic and political conditions, including disruptions in trading markets; • restrictive foreign governmental actions, including restrictions on transfers of funds and trade protection measures, including export duties and quotas and customs duties and tariffs; • changes in legal or regulatory requirements affecting foreign investment, loans, taxes, imports, and exports; • currency exchange rate fluctuations which, depending upon the nature of the changes, may make our finished products more expensive compared to foreign grown products or may increase our cost of obtaining foreign-sourced raw materials; and • earthquakes, tsunamis, floods or other major disasters may limit the supply of nuts that we purchase abroad |
| Any of these international business risks could have a material and adverse effect on our operating results |
| Increased costs associated with product processing and transportation, such as water, electricity, natural gas and fuel, could increase our expenses and reduce our profitability |
| Also, transportation costs represent a significant portion of the cost of our products, as we deliver our products and receive our raw materials via third party truck and rail companies |
| The prices of energy, water, and transportation costs such as fuel prices and labor costs, fluctuate significantly over time |
| We may not be able to pass on increased costs of production or transportation to our customers |
| In addition, from time to time, transportation service providers have a backlog 10 _________________________________________________________________ [59]Table of Contents of shipping requests, which could impact our ability to ship products in a timely fashion |
| Increases in the cost of water, electricity, natural gas, fuel or labor, and failure to ship products on time, could substantially harm our business and results of operations |
| A disruption at any of our production facilities would significantly decrease production, which could increase our cost of sales and reduce our income from operations |
| A temporary or extended interruption in operations at any of our facilities, whether due to technical or labor difficulties, destruction or damage from fire or earthquake, infrastructure failures such as power or water shortages or any other reason, whether or not covered by insurance, could interrupt our manufacturing operations, disrupt communications with our customers and suppliers and cause us to write off inventory and to lose sales |
| These risks to our business are particularly acute with respect to our Stockton, California facility, where we produced products accounting for over 80prca of our net sales for 2006 |
| Further, current and potential customers might not purchase our products if they perceive our lack of an alternate manufacturing facility to be a risk to their continuing source of products |
| The acquisition of other businesses could pose risks to our profitability |
| We intend to review acquisition prospects that we believe would complement our existing business |
| Future acquisitions could result in accounting charges, potentially dilutive issuances of equity securities, and increased debt and contingent liabilities, any of which could have a material adverse effect on our business and the market price of our common stock |
| Acquisitions entail many risks, including the integration of the acquired operations, diversion of management’s attention, risks of entering markets in which we have limited prior experience, and the potential loss of key employees of acquired organizations |
| We may be unable to integrate successfully businesses or the personnel of any business that might be acquired in the future, and our failure to do so could have a material adverse effect on our business and on the market price of our common stock |
| We recently acquired certain net assets from Harmony Foods Corporation, and it is difficult to determine what the impact of the acquisition on our financial results will be |
| We completed our acquisition of certain net assets from Harmony Foods Corporation on May 9, 2006, so we have only a very limited operating history on which to base an evaluation of our combined business and prospects |
| In addition, we may experience difficulties integrating the personnel, products, technologies and operations of the Harmony business |
| Our future success will depend on many factors that are not under our control, such as the following: • successful integration of Harmony products and personnel with our offerings and business; • growth in demand for the Harmony products; • consolidating our Lemont, Illinois operations with operations in Fishers, Indiana; • assimilating acquired assets and operations into our existing operations infrastructure; and • improving profitability of Harmony operations |
| Our business could be negatively impacted if we fail to maintain satisfactory labor relations |
| The success of our business depends substantially upon our ability to maintain satisfactory relations with our employees |
| The production and distribution employees working in our Stockton, California plant, who represent approximately 70prca of our year-round work force, are members of the International Brotherhood of Teamsters |
| If a work stoppage or slow down were to occur under our collective bargaining agreement, in connection with the negotiation of a new contract in March 2010 or otherwise, it could adversely affect our business and disrupt our operations |