Diamond Foods (DMND) 10-Q 2006 Q3 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended April 30, 2006

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                    to                    

Commission File Number: 000-51439

DIAMOND FOODS, INC.

(Exact name of registrant as specified in its charter)

Delaware	20-2556965
(State of Incorporation)	(IRS Employer Identification No.)
1050 South Diamond Street
Stockton, California	95205-7087
(Address of Principal Executive Offices)	(Zip Code)
209-467-6000
(Telephone No.)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filero Accelerated filero Non-accelerated filerþ

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yeso Noþ

Number of shares of common stock outstanding as of April 30, 2006: 15,678,111

TABLE OF CONTENTS

PART I — FINANCIAL INFORMATION
	ITEM 1. Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
Part II — Other Information
Item 1. Legal Proceedings
	Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
	Item 3. Defaults Upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits
Signature
EXHIBIT 31.01
EXHIBIT 31.02
EXHIBIT 32.01

TABLE OF CONTENTS

	Page
Part I. Financial Information		3
Item 1. Financial Statements		3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		12
Item 3. Quantitative and Qualitative Disclosure About Market Risk		23
Item 4. Controls and Procedures		23
Part II.Other Information		23
Item 1. Legal Proceedings		23
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		24
Item 3. Defaults Upon Senior Securities		24
Item 4. Submission of Matters to a Vote of Security Holders		24
Item 5. Other Information		24
Item 6. Exhibits		25
SIGNATURE		25
EXHIBIT 31.01
EXHIBIT 31.02
EXHIBIT 32.01

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

The statements contained in this Quarterly Report regarding our future financial and operating performance and results, business strategy, market prices, future commodity prices, plans and forecasts and other statements that are not historical facts are forward-looking statements. We use the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “seek” and other similar expressions to identify forward-looking statements many of which discuss our future expectations, contain projections of our results of operations or financial condition or state other “forward-looking” information. We have based these forward-looking statements on our assumptions, expectations, and projections about future events only as of the date of this Quarterly Report.

These forward-looking statements also involve many risks and uncertainties that could cause actual results to differ from our expectations in material ways. Please refer to the risks and uncertainties discussed in the section titled “Risk Factors.” You also should carefully consider other cautionary statements elsewhere in this Quarterly Report and in other documents we file from time to time with the Securities and Exchange Commission, including our most recent Annual Report on Form 10-K and other Quarterly Reports on Form 10-Q filed by us during our 2006 fiscal year. We do not undertake any obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this report.

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PART I — FINANCIAL INFORMATION

ITEM 1. Financial Statements

DIAMOND FOODS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)
(unaudited)

	April 30,			July 31,
	2006			2005
ASSETS
Current assets:
Cash and cash equivalents	$	20,212		$	49,035
Trade receivables, less allowance for doubtful accounts of $668 and $515, respectively		33,677			42,246
Inventories		141,232			111,270
Deferred income taxes		1,409			2,726
Prepaid expenses and other current assets		10,294			5,169
Total current assets		206,824			210,446
Property, plant and equipment, net		29,894			27,658
Investment in CoBank		2,191			2,269
Deferred income taxes		2,118			5,133
Other assets		5,241			6,522
Total	$	246,268		$	252,028
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Notes payable — members	$	—		$	2,119
Payable to members for membership interest		—			17,329
Accounts payable and accrued liabilities		26,136			29,422
Payable to growers		82,378			72,554
Total current liabilities		108,514			121,424
Long-term obligations		20,000			20,000
Other liabilities		11,279			11,142
Commitments and contingencies
Stockholders’ equity:
Common stock, $0.001 par value; Authorized:
100,000,000 shares; 15,678,111 and 15,555,506 shares issued and outstanding at April 30, 2006 and July 31, 2005, respectively		16			16
Additional paid-in capital		92,539			88,491
Other comprehensive loss		(74	)		—
Retained earnings		13,994			10,955
Total stockholders’ equity		106,475			99,462
Total	$	246,268		$	252,028

See notes to condensed consolidated financial statements.

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DIAMOND FOODS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (2006)/
CONDENSED CONSOLIDATED STATEMENTS OF NET PROCEEDS (2005)
(In thousands, except per share amounts)
(unaudited)

	Statements of					Statements of Net
	Operations					Proceeds
	Three			Nine		Three			Nine
	months			months		months			months
	ended			ended		ended			ended
	April 30, 2006					April 30, 2005
Net sales and other revenues	$	67,798		$	370,015	$	79,633		$	364,879
Patronage inventory at beginning of period		—			—		(153,041	)		(101,403	)
Patronage inventory at end of period		—			—		115,148			115,148
Net sales (2006)/ Gross marketing pool proceeds (2005)		67,798			370,015		41,740			378,624
Cost of sales		59,370			317,436		33,004			147,734
Cost of sales-NRV amount		—			2,770		—			—
Total cost of sales		59,370			320,206		33,004			147,734
Gross margin (2006)/ Proceeds before operating expenses (2005)		8,428			49,809		8,736			230,890
Operating expenses:
Selling, general and administrative (includes $906 and $2,797 for the three and nine months ended April 30, 2006 of stock-based compensation)		8,168			26,356		7,190			25,107
Advertising		5,399			16,286		4,113			18,496
Total operating expenses		13,567			42,642		11,303			43,603
Income (loss) from operations (2006)/Operating proceeds (deficiency) (2005)		(5,139	)		7,167		(2,567	)		187,287
Interest expense (income), net		(61	)		211		1,114			3,236
Conversion costs		—			—		56			245
Other		116			332		—			—
Income (loss) before income tax expense (benefit)(2006)/Proceeds (deficiency) before income tax expense (benefit) (2005)		(5,194	)		6,624		(3,737	)		183,806
Income tax expense (benefit)		(2,019	)		2,648		(505	)		(2,003	)
Net income (loss) (2006)/Net proceeds (deficiency) (2005)	$	(3,175	)	$	3,976	$	(3,232	)	$	185,809
Earnings (loss) per share:
Basic	$	(0.20	)	$	0.25
Fully-diluted	$	(0.20	)	$	0.25
Shares used to compute earnings (loss) per share:
Basic		15,668			15,604
Fully-diluted		15,668			15,630

See notes to condensed consolidated financial statements.

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DIAMOND FOODS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(unaudited)

	Nine months ended April 30,
	2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (2006) /Net proceeds (2005)	$	3,976		$	185,809
Adjustments to reconcile net income (2006)/net proceeds (2005) to net cash used in operating activities:
Depreciation and amortization		3,613			3,287
Deferred income taxes		4,332			—
Stock-based compensation		2,797			—
Impairment loss on equipment		440			—
CoBank patronage dividend paid in stock		—			(119	)
Changes in assets and liabilities:
Trade receivables		8,569			(8,642	)
Inventories		(29,962	)		(22,727	)
Prepaid expenses and other current assets		(5,125	)		(2,853	)
Other assets		1,281			991
Accounts payable and accrued liabilities		(3,360	)		2,781
Payable to growers		9,824			—
Other liabilities		777			781
Adjustment to current member account for change in prepaid inventory costs		—			4,845
Cash payments to members		—			(187,951	)
Net cash used in operating activities		(2,838	)		(23,798	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(6,318	)		(7,858	)
Other		107			100
Net cash used in investing activities		(6,211	)		(7,758	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Notes payable borrowings (repayments), net		(2,119	)		31,348
Additions to long-term obligations		—			10,000
Payments of long-term obligations		—			(10,000	)
Issuance of common stock under stock plans		611			—
Dividends paid		(937	)		—
Net proceeds from initial public offering paid to members		(17,329	)		—
Net cash provided by (used in) financing activities		(19,774	)		31,348
Net decrease in cash and cash equivalents		(28,823	)		(208	)
Cash and cash equivalents:
Beginning of period		49,035			780
End of period	$	20,212		$	572
Supplemental disclosures of cash flow information:
Cash paid (received) during the period for:
Interest	$	871		$	3,106
Income taxes		2,176			(373	)
Accrued liability exchanged for options to acquire common stock		640			—

See notes to condensed consolidated financial statements.

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DIAMOND FOODS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the three and nine months ended April 30, 2006 and 2005
(In thousands, except share and per share information)

(1) Organization and Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Diamond Foods, Inc. (the “Company” or “Diamond”) have been prepared in accordance with generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for annual financial statements. The accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements at and for the year ended July 31, 2005, except as described below, and, in the opinion of management include all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of the Company’s financial condition at April 30, 2006, and the results of the Company’s operations for the three and nine months ended April 30, 2006 and 2005 and cash flows for the nine months ended April 30, 2006 and 2005. These unaudited interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s 2005 Annual Report on Form 10-K. Operating results for the nine months ended April 30, 2006 are not necessarily indicative of the results that may be expected for the year ended July 31, 2006.

On July 26, 2005, after receiving required approvals and meeting certain conditions, Diamond Walnut Growers, Inc. converted from an agricultural cooperative association to a Delaware corporation through a merger with and into its wholly owned subsidiary, Diamond, and at the same time completed an initial public offering of Diamond’s common stock.

The accompanying condensed consolidated statements of net proceeds for the three and nine months ended April 30, 2005 have been prepared in accordance with GAAP for agricultural cooperative associations. Effective August 1, 2005 the Company began to prepare its financial statements in accordance with GAAP for companies that are not agricultural cooperative associations. The principal difference relates to accounting for walnut inventories received from cooperative members. As a cooperative association, Diamond used the net realizable value method to value these inventories. Walnuts received by Diamond subsequent to July 31, 2005 are accounted for under the lower of cost (first-in, first-out), or market method. As a result, the statements of operations for the three and nine months ended April 30, 2006 and the statements of net proceeds for the three and nine months ended April 30, 2005 are not comparable.

Certain prior year financial statement amounts have been reclassified to conform to the current year classification.

Total comprehensive income (loss) for the three and nine months ended April 30, 2006, was $(3,249) and $3,902, respectively.

(2) Stock-Based Compensation

The Company has various stock-based compensation programs, which provide for equity awards including stock options and restricted stock. On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004),Share-Based Payment,which is a revision of SFAS No. 123,Accounting for Stock-Based Compensation. The statement supercedes APB Opinion No. 25,Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS No. 123R requires all entities to recognize compensation expense in an amount equal to the fair value of share-based awards. Beginning with its adoption by the Company in August 2005, the fair value of all stock options granted subsequent to July 20, 2005 will be recognized as an expense in the Company’s statement of operations, typically over the related vesting period of the

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options. SFAS No. 123R requires use of fair value computed at the date of grant to measure share-based awards. The fair value of restricted stock awards is recognized as stock-based compensation expense over the vesting period, generally three years from date of grant or award. Stock options may be granted to officers, employees and directors. As required under SFAS No.123R the Company continues to account for stock-based compensation for options granted prior to August 1, 2005 using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, since the options were granted at market price, no compensation expense is recognized. As required by SFAS No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123, the Company has provided fair value based pro-forma disclosures in its interim financial statements related to these options.

If compensation expense for the Company’s various stock option plans had been determined based upon the projected fair values at the grant dates for all awards in accordance with SFAS No. 123,Accounting for Stock-Based Compensation, the Company’s pro-forma net income, basic and diluted earnings per common share would have been as follows:

	Three			Nine
	months			months
	ended			ended
	April 30, 2006
Net income (loss), as reported	$	(3,175	)	$	3,976
Total stock-based compensation recorded in the statement of operations, net of related tax effects		554			1,678
Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects		(842	)		(2,497	)
Pro forma net income (loss)	$	(3,463	)	$	3,157
Net income (loss) per common equivalent share:
Basic — as reported	$	(0.20	)	$	0.25
Basic — pro forma	$	(0.22	)	$	0.20
Diluted — as reported	$	(0.20	)	$	0.25
Diluted — pro forma	$	(0.22	)	$	0.20

Stock Option Awards:The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model. Expected stock price volatilities are estimated based on the Company’s implied historical volatility. The expected term of options granted and forfeiture rates are based on assumptions and historical data to the extent it is available. The risk-free rates are based on U.S. Treasury yields, for notes with comparable terms as the option grants, in effect at the time of the grant. For purposes of this valuation model, dividends are based on the historical rate. Assumptions used in the Black-Scholes model are presented below:

	Nine months ended
	April 30, 2006
Average expected life, in years		6.0
Expected volatility		27.5	%
Risk-free interest rate		4.75	%
Dividend rate		0.64	%

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The following table summarizes option activity during the nine months ended April 30, 2006:

						Weighted average
	Number of			Weighted		remaining		Aggregate
	Shares			average exercise		contractual life		intrinsic value
	(in thousands)			price per share		(in years)		(in thousands)
Outstanding at July 31, 2005		1,123		$	17.00
Granted		522			18.89
Exercised		—			—
Cancelled		(75	)		17.40
Outstanding at April 30, 2006		1,570		$	17.61		9.3	$	2,182
Exercisable at April 30, 2006		—		$	—			$	—

The weighted average fair value of options granted during the three and nine months ended April 30, 2006 was $6.07 and $6.39, respectively.

Changes in the Company’s nonvested options during the nine months ended April 30, 2006 are summarized as follows:

				Weighted
	Number of			average grant
	shares			date fair value per
	(in thousands)			share
Nonvested at July 31, 2005		1,123		$	5.50
Granted		522			6.39
Vested		—			—
Cancelled		(75	)		5.64
Nonvested at April 30, 2006		1,570		$	5.79

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As of April 30, 2006, there was $7.3 million of total unrecognized compensation cost related to nonvested stock options, which is expected to be recognized over a weighted average period of 2.6 years.

Restricted Stock Awards:As of April 30, 2006, there were 678 shares of restricted stock outstanding. Restricted stock activity during the nine months ended April 30, 2006 is summarized as follows:

	Number of
	shares
	(in thousands)
Outstanding at July 31, 2005		598
Granted		101
Exercised		—
Cancelled or expired		(21	)
Outstanding at April 30, 2006		678

The weighted average grant date fair value of restricted stock awards granted during the three and nine months ended April 30, 2006 was $17.67 and $20.03, respectively.

As of April 30, 2006, there was $7.1 million of unrecognized compensation cost related to nonvested restricted stock awards, which is expected to be recognized over a weighted average period of 2.3 years.

(3) Earnings Per Share

Options to purchase 1,570 shares of common stock at prices ranging from $16.07 to $21.00 per share were outstanding at April 30, 2006. Basic earnings per share is calculated using the weighted average number of common shares outstanding during the period. Diluted earnings per share is calculated using the weighted average number of common shares and includes the dilutive effect of common shares issuable upon the exercise of outstanding options, calculated using the treasury stock method. Options to purchase 1,570 and 600 shares of common stock were not included in the computation of diluted earnings per share for the three and nine months ended April 30, 2006, respectively, because their effect would be antidilutive.

(4) Balance sheet items

Inventories consisted of the following:

	April 30,		July 31,
	2006		2005
Raw materials and supplies	$	65,771	$	33,949
Work in process		23,985		30,732
Finished goods		51,476		46,589
Total	$	141,232	$	111,270

In November 2004, SFAS No. 151,Accounting for Inventory Costs, was issued. SFAS No. 151 requires allocation of fixed production overheads to inventories based on the normal capacity of the production facilities. Unallocated overhead must be recognized as an expense in the period incurred. This statement was effective for inventory costs incurred beginning in August, 2005 and its adoption had no material impact on Diamond’s financial statements.

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Accounts payable and accrued liabilities consisted of the following:

	April 30,		July 31,
	2006		2005
Accounts payable	$	15,432	$	15,677
Accrued salaries and benefits		3,820		3,686
Accrued promotion		4,591		5,241
Other		2,293		4,818
Total	$	26,136	$	29,422

(5) Foreign Currency Hedging

To reduce the risk of foreign currency exchange movements, Diamond periodically enters into forward contracts. These derivative instruments have settlement dates generally less than one year, are recorded at fair value, and are included in accrued liabilities (balances at April 30, 2006 and July 31, 2005 were not material). At April 30, 2006 Diamond had outstanding forward contracts to deliver 3.0 million Euros at various dates through January 2007. These contracts had an average exchange rate of 1.23 US Dollars per Euro. Forward contracts totaling $1.1 million Euros are designated as cash flow hedges in accordance with SFAS No. 133,“Derivative Financial Instruments and Hedging.”Accordingly, changes in derivative fair values are deferred and recorded as a component of other comprehensive income until the underlying transaction is recorded in earnings. In the period in which the hedged item affects earnings, gains or losses on the derivative instrument are reclassified from other comprehensive income to operating income. Diamond assesses, both at the inception of the hedge and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in cash flows of hedged items.

(6) Credit Facilities

The Company has an unsecured master loan agreement with CoBank that provides for both a revolving line of credit in an aggregate principal amount of $77.5 million bearing interest at LIBOR plus 0.65% per annum and a long-term revolver that provides an aggregate principal amount of $20.0 million bearing interest at LIBOR plus 0.7% per annum. The revolving line of credit agreement expires on April 1, 2008 and the long-term revolving agreement expires on April 1, 2011. The master loan agreement governing these credit facilities subjects the Company to financial and other covenants and contains customary events of default. As of April 30, 2006 and July 31, 2005, the Company had no amount outstanding on the revolving line of credit and no borrowings on the long-term revolver.

The Company has a credit agreement with another bank that provides for an unsecured revolving line of credit in an aggregate principal amount of $32.5 million and a $2.0 million letter of credit facility. The revolving line of credit expires on January 15, 2007 and bears interest at LIBOR plus 0.65% per annum. The credit agreement governing these notes subjects the Company to financial and other covenants and contains customary events of default. As of April 30, 2006 and July 31, 2005, the Company had no amount outstanding on the revolving line of credit.

The Company has $20.0 million of senior notes outstanding with two institutional investors. The Company is required to make annual principal repayments on these notes in the amount of $4.0 million starting December 2009. The notes mature in December 2013 and bear interest at a rate of 7.35%. The Company is subject to certain affirmative and negative covenants specified in the senior note agreement.

As of April 30, 2006 and July 31, 2005, the Company was in compliance with all applicable covenants of its credit facilities.

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(7) Retirement Plans

Diamond provides retiree medical benefits and sponsors three defined benefit pension plans — a qualified plan covering all salaried employees, a qualified plan covering all regular hourly employees, and a nonqualified plan for certain salaried employees. The amounts shown for pension benefits are combined amounts for all three plans. Diamond uses an August 1 measurement date for its plans. Plan assets are held in trust and primarily include mutual funds and money market accounts. Any employee who joined the Company following January 15, 1999 is not entitled to retiree medical benefits.

Components of net periodic benefit cost for the three months and nine months ended April 30 were as follows:

	Pension Benefits												Other Benefits
	Three months ended						Nine months ended						Three months ended				Nine months ended
	April 30,						April 30,						April 30,				April 30,
	2006			2005			2006			2005			2006		2005		2006		2005
Service cost	$	559		$	464		$	1,676		$	1,391		$	64	$	69	$	190	$	205
Interest cost		432			438			1,295			1,314			135		148		407		442
Expected return on plan asset		(575	)		(571	)		(1,725	)		(1,713	)
Amortization of prior service cost		(72	)		(72	)		(215	)		(215	)
Amortization of net loss		202			154			606			462
Other		—			—			—			—			5		8		15		26
Net periodic benefit cost	$	546		$	413		$	1,637		$	1,239		$	204	$	225	$	612	$	673

Defined Contribution Plan— The Company recognized defined contribution plan expenses of $70, $94, and $244 and $270 for the three and nine months ended April 30, 2006 and 2005, respectively.

(8) Contingencies

The Company is the subject of various legal actions in the ordinary course of business. All such matters are subject to many uncertainties that make their outcomes unpredictable.

The Company and PG&E are parties to an agreement pursuant to which the Company agreed to provide to PG&E electric power produced from a cogeneration facility owned by the Company. In November 2005, the Company notified PG&E that it ceased operating the facility. The agreement provides for potential payments by the Company to PG&E in the event the Company terminates the contract. On February 3, 2006, PG&E filed a complaint in San Francisco County Superior Court alleging, among other things, breach of contract as a result of the Company’s decision to cease operating the facility. PG&E’s complaint seeks payment of approximately $1.4 million from the Company plus interest under the contract’s termination provisions as well as PG&E’s costs for the lawsuit. The Company believes that the termination payment provision constitutes an unenforceable penalty and intends to vigorously defend itself against PG&E’s lawsuit. The Company believes that the ultimate liability, if any, resulting from the eventual outcome of this matter will not be material to Diamond’s financial condition or operating results.

(9) Subsequent Events

In May 2006, the Company acquired certain assets of Harmony Foods Corporation (“Harmony”) for $18 million and the assumption of certain specified liabilities. Harmony develops, processes and markets snack food products. Among the assets acquired were Harmony’s processing and packaging facility and equipment, certain brands and working capital. The acquisition will be accounted for as a purchase and the final purchase price allocation has not yet been determined. Concurrent with this acquisition, Diamond announced a restructuring whereby it will close its Lemont, Illinois facility and will conduct these activities in the plant acquired in the Harmony transaction. Diamond eliminated 20 positions and expects to incur approximately $1 million of restructuring and related costs over the next six months.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a branded food company specializing in processing, marketing and distributing culinary, snack, in-shell, and ingredient nuts. Our company was founded in 1912 and has a strong heritage in the walnut market under the Diamond of California brand. On July 26, 2005 we converted from an agricultural cooperative association to a Delaware corporation and completed the initial public offering of our common stock. As a public company, our focus will be on building stockholder value. We intend to expand our existing business, and to continue to introduce higher-value branded products in our culinary and snack businesses, including snack products marketed under our Emerald brand name. Our products include walnuts, pine nuts, pecans, peanuts, macadamia nuts, hazelnuts, cashews, Brazil nuts, and almonds. Our products are sold in over 60,000 retail locations in the United States and in over 100 countries. We sell products to approximately 900 customers, including approximately 150 international customers. In general, we sell directly to retailers, particularly large, national grocery store and drug store chains, and indirectly through wholesale distributors who serve independent and small regional retail grocery store chains and convenience stores. We also sell our products to mass merchandisers, club stores, convenience stores, and through other retail channels.

Our business is seasonal. Demand for nut products, particularly in-shell nuts and to a lesser extent, culinary nuts, is highest during the months of October, November and December. We receive our principal raw material, walnuts, during the period from September to November and process it throughout the year. As a result of this seasonality, our personnel and working capital requirements and walnut inventories peak during the last quarter of the calendar year. This seasonality also impacts capacity utilization at our facilities, which routinely operate at capacity for the last four months of the calendar year.

A disproportionate amount of our net sales and related net income (net proceeds prior to July 31, 2005) are recognized in the first half of our fiscal year. For example, net sales in the first half of 2005 and 2004 were 61.7% and 64.8% of net sales for each full fiscal year. In the near term, we expect a higher percentage of our net income to be earned in the first half of our fiscal year because many of our operating costs are fixed and cannot be reduced when net sales are lower quarter to quarter. However, as we continue to introduce new products, such as snack products, we expect net sales, and related net income, to be less seasonal.

The historical financial information contained herein for fiscal year 2005 has been derived from financial statements prepared in accordance with GAAP for agricultural cooperative associations. Effective August 1, 2005, our financial statements have been prepared in accordance with GAAP for companies that are not cooperative associations. The principal difference relates to accounting for walnut inventories. As an agricultural cooperative association, crop year pools were established for members’ walnuts. In addition, net patronage proceeds or losses from the sale of walnuts were allocated to members by crop year pool. Payments to members were specifically identified as to crop year pool.

Furthermore, as an agricultural cooperative association we used the net realizable value, or NRV, method to value walnut inventories delivered by members. NRV is the estimated sales price of inventories less estimated completion, distribution and selling costs. As a result of crop pool accounting and the NRV method of valuing inventories, our financial statements prior to August 1, 2005 do not include a cost of goods sold for walnuts received from members. Effective August 1, 2005, we were not eligible to use crop year pool accounting and NRV; therefore, we now account for purchases of walnuts from growers on a lower of cost or market basis. Consequently, the results of operations reported subsequent to fiscal year 2005 will be significantly different than net proceeds reported in fiscal years 2005 and prior.

Critical Accounting Policies

Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenue and expenses. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the

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circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. Our critical accounting policies are set forth below.

Revenue Recognition.We recognize revenue when a persuasive arrangement exists, title has transferred (based upon terms of shipment), price is fixed, delivery occurs and collection is reasonably assured. Revenues are recorded net of rebates, coupons, promotion and marketing allowances. Customers have the right to return certain products. These product returns are estimated based upon historical results and reflected as a reduction in net sales.

Inventories.Effective August 1, 2005, all inventories are accounted for on a lower of cost (first-in, first-out) or market basis. Prior to that date, as a cooperative association, we recorded walnut inventories acquired from members at estimated net realizable value (estimated sales price less estimated completion, distribution and selling costs). We estimated sales prices and costs based on historical experience and other assumptions that we believe were reasonable. Actual results could have differed materially from these estimates. All other inventories were stated at the lower of cost (first in, first out) or market.

In connection with our July 2005 initial public offering, we entered into long-term Walnut Purchase Agreements with substantially all of our former member growers. Under these agreements, growers will deliver their entire walnut crop to us during the Fall harvest season and we will announce a purchase price for this inventory by March 31 of the following year. This purchase price will be a market-based price determined by Diamond in good faith, taking into account market conditions, crop size, quality, and varieties, among other relevant factors. Since the ultimate price to be paid will be determined each March subsequent to receiving the walnut crop, management must make an estimate of this price for the first and second quarter interim financial statements. These estimates are subject to change and such changes, if any, could be material. We determined the purchase price for the 2005 crop during the three months ended April 30, 2006. This determination had no material impact.

Impairment of Long-Lived Assets.We review long-lived assets to assess recoverability from projected undiscounted cash flows whenever events or changes in facts and circumstances indicate that the carrying value of the assets may not be recoverable. Any impairment loss is recognized in operating results when future undiscounted cash flows are less than the assets’ carrying value. The impairment loss would reduce the carrying value of an asset to its fair value.

Employee Benefits.We incur various employment-related benefit costs with respect to qualified and nonqualified pension and deferred compensation plans. Assumptions are made related to discount rates used to value certain liabilities, assumed rates of return on assets in the plans, compensation increases, employee turnover and mortality rates. We utilize third-party actuarial firms to assist us in determining appropriate assumptions and plan valuations. Different assumptions could result in the recognition of differing amounts of expense over different periods of time.

Income Taxes.We account for income taxes in accordance with SFAS No. 109,Accounting for Income Taxes,which requires that deferred tax assets and liabilities be recognized for the tax effect of temporary differences between the financial statement and tax basis of recorded assets and liabilities at current tax rates. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. The recoverability of deferred tax assets is based on both our historical and anticipated earnings levels and is reviewed periodically to determine if any additional valuation allowance is necessary when it is more likely than not that amounts will not be recovered.

Supplemental and Non-GAAP Financial Information

Diamond has provided non-GAAP financial information for the nine months ended April 30, 2006, which excludes a one time charge to cost of sales as a result of the conversion from a cooperative to a public company in July 2005. This charge relates to the company’s use of net realizable value (NRV) accounting for certain inventories acquired prior to August 1, 2005. Starting August 1, 2005 Diamond began using the lower of cost or market method of valuing walnut inventories acquired subsequent to that date. As a result of using NRV accounting, these inventories were valued higher than they would have been under the lower of cost or market method. Therefore, the amount charged to cost of goods sold was higher as these

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inventories were sold during the period ended October 31, 2005. Since all of these inventories were sold as of that date, future cost of sales will not include similar NRV charges.

Furthermore, beginning August 1, 2005, Diamond’s cost basis for walnuts is the price it pays for them. For the three and nine months ended April 30, 2005, the following supplemental financial information, including estimated walnut acquisition costs, is presented for purposes of comparing Diamond’s financial results in 2006 to 2005. Estimated walnut acquisition costs are based on the “field price” reported by the California Statistical Office of the USDA National Agricultural Statistics Service, or CASS, for each related crop year. Diamond believes this information is the only available measure of industry-wide walnut acquisition costs. Diamond cannot determine an actual cost basis for walnuts acquired and sold in historical periods. In addition, Diamond:

• is unable to determine retroactively what it would have paid for walnuts in prior years had it not been a cooperative;

• is unable to determine whether what it would have paid for walnuts would approximate amounts paid to other growers by other processors as reflected in the CASS statistics;

• is limited by the level of detail provided by the CASS statistics; and

• cannot ensure that the cost of sales amounts implied by the CASS statistics are representative of future cost of sales amounts.

Diamond has not undertaken any effort to validate the accuracy of the CASS statistics.

	Three months ended April 30,				Nine months ended April 30,
	2006		2005		2006		2005
			(supplemental)		(non-GAAP)		(supplemental)
(in thousands)	(unaudited)				(unaudited)
Net sales and other revenues	$	67,798	$	79,633	$	370,015	$	364,879
Cost of sales		59,370		74,708		317,436		320,910
Gross margin	$	8,428	$	4,925	$	52,579	$	43,969

A reconciliation of GAAP to non-GAAP and supplemental information (in thousands, except per share amounts) is as follows:

	Three months ended			Nine months ended
	April 30,			April 30,
		2005		2006			2005
GAAP cost of sales		$	33,004	$	320,206		$	147,734
Adjustment to remove one time impact of accounting for certain inventories on NRV basis			—		(2,770	)		—
Adjustment to convert walnut inventories from crop year pool and NRV accounting to cost basis accounting and to record estimated walnut cost of goods sold			41,704		—			173,176
Non-GAAP/supplemental cost of sales		$	74,708	$	317,436		$	320,910

About Diamond’s supplemental and non-GAAP Financial Measures

This Form 10-Q contains supplemental and non-GAAP financial measures of Diamond’s performance (“non-GAAP measures”) for different periods. Non-GAAP measures should not be considered as a substitute for financial measures prepared in accordance with GAAP. Diamond’s non-GAAP measures do not reflect a comprehensive system of accounting, and differ both from GAAP financial measures and from

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non-GAAP measures used by other companies. Diamond urges investors to review its reconciliation of non-GAAP measures to GAAP financial measures, and its financial statements to evaluate its business.

Diamond believes that its non-GAAP measures provide meaningful information regarding operating results because they exclude amounts that Diamond excludes when monitoring operating results and assessing performance of the business. Diamond believes that its non-GAAP measures also facilitate comparison of results for current periods and business outlook for future periods. Diamond non-GAAP measures include the following adjustments:

• Diamond excludes a one-time charge that it incurred in connection with its conversion. As an agricultural cooperative association, Diamond was required to use net realizable value (NRV) accounting for certain inventories; as a for-profit corporation Diamond is required to use the lower of cost or market method to value all inventories. As a result of using NRV accounting, certain inventories were valued higher than they would have been under the lower of cost or market method. Therefore, as these inventories were sold, the amount charged to cost of goods sold was higher. Diamond excluded this charge because it is non-recurring and is not indicative of ongoing operations.

• Diamond includes the estimated cost of walnuts received from members in 2005. Diamond’s management believes that information is useful to investors because Diamond’s financial statements for periods after July 31, 2005 include walnut acquisition costs that were not included in its financial statements for earlier periods. Accordingly, gross margins after this date will be materially different than those reported in the historical cooperative financial statements.

Diamond’s management uses non-GAAP measures in internal reports used to monitor and make decisions about its business, such as monthly financial reports prepared for management. The principal limitation of the non-GAAP measures is that they exclude significant expenses required under GAAP. They also reflect the exercise of management’s judgments about which adjustments are appropriately made. To mitigate this limitation, Diamond presents the non-GAAP measures in connection with GAAP results, and recommends that investors do not give undue weight to them. Diamond believes that non-GAAP measures provide useful information to investors by allowing them to view the business through the eyes of management, facilitating comparison of results across historical and future periods, and providing a focus on the underlying operating performance of the business.

Results of Operations

Net sales were $67.8 million and $79.6 million for the three months ended April 30, 2006 and 2005. Net sales were $370.0 million and $364.9 million for the nine months ended April 30, 2006 and 2005. For the three months ended April 30, 2006, volume decreased from 32.2 million pounds sold in 2005 to 23.8 million pounds sold in 2006, a decrease of 26.1%. For the nine months ended April 30, 2006, volume decreased from 187.6 million pounds sold in 2005 to 156.4 million pounds sold in 2006, a decrease of 16.6%. The decrease in volume was offset in part, by higher average selling prices. The increase in selling prices reflected higher commodity costs for raw materials, a portion of which we were able to pass on to customers. This higher pricing was principally for walnuts, pecans and almonds in the North American Retail channel, shelled walnuts in the North American Ingredient/Food Service channel and in-shell and shelled walnuts in the International channel.

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Net sales by channel (in thousands):

	Three months ended						Nine months ended
	April 30,						April 30,
	2006		2005				2006		2005
North American Retail (1)	$	34,943	$	35,399	(1.3	)%	$	221,108	$	188,502	17.3	%
International		15,585		21,483	(27.5	)		84,921		97,415	(12.8	)
North American Ingredient/Food Service		16,461		21,436	(23.2	)		61,272		75,699	(19.1	)
Other		809		1,315	(38.5	)		2,714		3,263	(16.8	)
Total	$	67,798	$	79,633	(14.9	)%	$	370,015	$	364,879	1.4	%

(1) North American Retail represents sales of our culinary, snack and in-shell nuts in North America.

The decrease in North American Retail sales for the three months ended April 30, 2006 reflects lower volume of culinary products at higher average selling prices. Additionally, Emerald product sales increased to $5.6 million in 2006 from $4.5 million in 2005. The increase in North American Retail sales for the nine months ended April 30, 2006 reflects the expansion of Emerald products sales, which were $24.1 million for 2006 compared to $14.2 million for 2005, price increases on various culinary and in-shell products, and volume increases for culinary products in the club and mass merchandisers channels, offset in part by volume decreases of in-shell products.

International and ingredient/food service sales declined in both the three and nine month periods ended April 30, 2006 compared to 2005 primarily as a result of less product available to sell due to lower ending inventories at July 31, 2005. This decline in volume was offset, in part, by higher pricing.

Sales of walnuts and other nuts as a percentage of net sales were:

	Three months ended						Nine months ended
	April 30,						April 30,
	2006			2005			2006			2005
Walnuts		70.1	%		73.3	%		67.2	%		71.5	%
Other nuts		29.9			26.7			32.8			28.5
Total		100.0	%		100.0	%		100.0	%		100.0	%

Sales to one customer represented approximately 23% and 20% of total net sales for the three and nine months ended April 30, 2006 (16% and 17% for the three and nine months ended April 30, 2005).

Gross margin.Gross margin for the three and nine months ended April 30, 2006 was 12.4% and 13.5%. The nine month amount included a one-time charge to cost of sales as described above. Excluding that charge, on a non-GAAP and supplemental basis as described above, gross margin for the three months ended April 30, 2006 and 2005 was 12.4% and 6.2%, and for the nine months ended April 30, 2006 and 2005 was 14.2% and 12.1%.

Selling, General and Administrative.Selling, general and administrative expenses consist principally of salaries and benefits for sales and administrative personnel, brokerage, professional services, travel and non-manufacturing depreciation and facility costs. Selling, general and administrative expenses were $8.2 million and $7.2 million for the three months ended April 30, 2006 and 2005, and $26.4 million and $25.1 million for the nine months ended April 30, 2006 and 2005. Selling, general and administrative expenses for the three and nine months ended April 30, 2006 included stock-based compensation charges of $0.9 million and $2.8 million. There was no such charge in the comparable periods in 2005.

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Advertising.Advertising expense was $5.4 million and $4.1 million for the three months ended April 30, 2006 and 2005 and $16.3 million and $18.5 million for the nine months ended April 30, 2006 and 2005. The change related principally to the timing of certain advertising programs.

Interest.Net interest expense was nil and $1.1 million for the three months ended April 30, 2006 and 2005, and $0.2 million and $3.2 million for the nine months ended April 30, 2006 and 2005. These decreases reflected lower borrowings due to repayment of indebtedness and utilization of cash from the July 2005 initial public offering to fund working capital requirements.

Income Taxes.Income tax expense (benefit) was ($2.0) million and $(0.5) million for the three months ended April 30, 2006 and 2005, and $2.6 million and $(2.0) million for the nine months ended April 30, 2006 and 2005. Under the federal tax code, until July 31, 2005, we were a nonexempt cooperative association. Nonexempt cooperatives accrue income taxes only on net non-patronage proceeds and certain expenses, which are not deductible for tax purposes. No provision for taxes was made for net patronage proceeds paid or allocated to members as qualified notices of allocation.

Effective August 1, 2005, all of our business activities are taxable under provisions of the Internal Revenue Code and certain state tax laws. Accordingly, we have provided for income taxes based on our estimated effective tax rate for the year of 40%.

Liquidity and Capital Resources

Our liquidity is dependent upon funds generated from operations and external sources of financing.

During the nine months ended April 30, 2006, cash used in operating activities was $2.8 million compared to $23.8 million for the nine months ended April 30, 2005. This decrease was principally due to improved management of working capital. Cash used in investing activities was $6.3 million in 2006 compared to $7.8 million in 2005, virtually all of which related to the purchases of equipment. Cash used in financing activities during 2006 was $19.8 million (as some of the IPO proceeds were paid to former members) compared to cash provided by financing activities of $31.3 million in 2005 (as borrowings were made to finance operations and capital expenditures).

As of January 31, 2006, we had a total of $20.0 million of senior notes outstanding with two institutional investors. We are required to make annual principal repayments on these notes in the amount of $4.0 million starting in December 2009. The notes mature in December 2013 and bear interest at a rate of 7.35% per annum. We are subject to certain affirmative and negative covenants outlined in the senior note agreement.

We also have an unsecured master loan agreement with CoBank that provides for both a revolving line of credit in an aggregate principal amount of $77.5 million bearing an interest rate of LIBOR plus 0.65% per annum, and a long-term revolver that provides an aggregate principal amount of $20.0 million bearing an interest rate of LIBOR plus 0.7% per annum. The revolving line of credit agreement expires on April 1, 2008 and the long-term revolving agreement expires on April 1, 2011. The master loan agreement governing these credit facilities subjects us to financial and other covenants and contains customary events of default. As of April 30, 2006, we had no amount outstanding on the revolving line of credit or on the long-term revolver.

As of April 30, 2006, we had a credit agreement with another bank that provides for an unsecured revolving line of credit in an aggregate principal amount of $32.5 million and a $2.0 million letter of credit facility. The revolving line of credit expires on January 15, 2007, and borrowings under this line of credit bear interest at a rate of LIBOR plus 0.65% per annum. The credit agreement governing these notes subjects us to financial and other covenants and contains customary events of default. As of April 30, 2006, we had no amount outstanding on the revolving line of credit.

As of April 30, 2006, we were in compliance with all applicable loan covenants under our credit facilities and, on a combined basis, we had $130 million of available borrowing capacity.

Working capital and stockholders’ equity were $98.3 million and $106.5 million at April 30, 2006 compared to $89.0 million and $99.5 million at July 31, 2005.

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We believe cash on hand, cash equivalents and cash expected to be provided from our operations, in addition to borrowings available under our existing lines of credit, will be sufficient to fund our contractual commitments, repay obligations as required, and meet our operational requirements through the year ended July 31, 2006.

Contractual Obligations and Commitments

Contractual obligations and commitments at April 30, 2006 are as follows (in millions):

	Payments Due by Fiscal Year
			2006		2007-		2009-		There-
	Total		(c)		2008		2010		after
Long-term obligations (a)	$	20.0	$	—	$	—	$	4.0	$	16.0
Interest on long-term obligations		8.5		0.7		2.9		2.7		2.2
Operating leases		2.9		0.2		1.3		1.1		0.3
Purchase commitments (b)		0.8		0.8		—		—		—
Total	$	32.2	$	1.7	$	4.2	$	7.8	$	18.5

(a)	Excludes $2.0 million in total letters of credit outstanding related to normal business transactions.
(b)	Commitments to purchase equipment.
(c)	Represents obligations and commitments for the remaining three months of fiscal 2006.

Effects of Inflation

There has been no material change in our exposure to inflation from that discussed in our 2005 Annual Report on Form 10-K.

Recent Accounting Pronouncements

In December 2004, SFAS No. 123(R),Share-Based Payment, was issued. This statement requires that compensation costs related to share-based awards be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based upon the grant date fair value of the security issued. In addition, liability awards will be remeasured each reporting period and compensation costs will be recognized over the period that an employee provides service in exchange for the award. This statement was effective for us beginning in the first quarter of fiscal 2006. The effect of adopting this statement in the three and nine months ended April 30, 2006 was an increase in compensations costs of $0.9 million and $2.8 million for restricted stock and for stock options granted subsequent to July 31, 2005.

In November 2004, SFAS No. 151,Accounting for Inventory Costs, was issued. Statement 151 requires allocation of fixed production overheads to inventories based on the normal capacity of the production facilities. Unallocated overhead must be recognized as an expense in the period incurred. This statement was effective for inventory costs incurred beginning in our 2006 fiscal year and adoption of the standard had no material impact on our financial statements.

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.

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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 or misbranded. Our products are subject to product tampering, and to contamination risks, such as mold, bacteria, insects and other pests, shell fragments 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. Adverse publicity could result in a loss of consumer confidence in our products. Product liability claims and product recalls could 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 65% of our net 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.

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.

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The impact of the conversion and initial public offering on our business is difficult to predict; it could disrupt existing relationships and harm our financial results.

From 1912 until July 2005 we operated as an agricultural cooperative association, and our management team has limited experience operating a public company. In connection with the conversion and initial public offering, our ownership changed, and our organizational mission shifted from delivering annual net proceeds to members to maximizing long-term stockholder value. If we do not manage this transition successfully, circumstances may arise that could increase our costs and decrease our profits. As a public company, we are subject to time-consuming and costly requirements of periodic reporting, corporate governance and accounting that will increase our costs and present new management challenges. The conversion may disrupt our relationships with growers, suppliers and employees and negatively impact our financial results.

Sales to our top customers represented over 20% of our net sales. The loss of any major customers could adversely impact our business.

We depend on a few significant customers for a large proportion of our net sales, particularly in our culinary business. This concentration has become more pronounced with the trend toward consolidation in the retail grocery store industry. Sales to one customer represented approximately 23% of total net sales for the three months ended April 30, 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. We incurred a net loss in the third quarter of fiscal 2006, reflecting this seasonality, and, may continue to do so in the future. Sales in the first and second fiscal quarters accounted for approximately 62% of our revenues for the year ended July 31, 2005. 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 the future, these growers could have lower processing costs than we do. 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, including Michael J. Mendes, President and Chief Executive Officer, who manages the day-to-day operation of our business. 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. We do not have key person insurance. The loss of the services of any of these individuals could have a material

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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 could disrupt our supply of imported nuts.

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 supply against the threat of intentional contamination. The U.S. 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.

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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 2005, sales outside the United States, primarily in Germany, Japan, Spain and Italy, accounted for approximately 30% 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.

We require a substantial amount of energy and water to process our nuts. Also, transportation costs represent a material 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. Increases in the cost of water, electricity, natural gas, fuel or labor 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 80% of our net sales for 2005. 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 would 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.

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We recently acquired 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 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; and

• assimilating acquired assets and operations into our existing operations infrastructure.

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 70% 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.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

There has been no material change in our exposure to market risk from that discussed in our 2005 Annual Report on Form 10-K.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of April 30, 2006. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

There were no significant changes in our internal control over financial reporting or in other factors identified in connection with the evaluation required by Exchange Act Rules 13a-15(e) or 15d-15(e) that was conducted during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls subsequent to the date we completed our evaluation.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

We are the subject of various legal actions in the ordinary course of our business. All such matters are subject to many uncertainties that make their outcomes unpredictable. On February 3, 2006, PG&E filed a

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complaint in San Francisco County Superior Court alleging, among other things, breach of contract as a result of the Company’s decision to cease operating the company’s cogeneration facility. PG&E’s complaint seeks payment of approximately $1.4 million from the Company plus interest under the contract’s termination provisions as well as PG&E’s costs for the lawsuit. The Company believes that the termination payment provision constitutes an unenforceable penalty and intends to vigorously defend itself against PG&E’s lawsuit. The Company believes that the ultimate liability, if any, resulting from the eventual outcome of this matter will not be material to Diamond’s financial condition or operating results.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The Securities and Exchange Commission declared our registration statement on Form S-1 (File No. 333-123576) filed under the Securities Act of 1933 in connection with the initial public offering of our common stock, $.001 par value per share, effective on July 20, 2005. The underwriters were Merrill Lynch & Co., Piper Jaffray and Harris Nesbitt.

Our initial public offering commenced on July 21, 2005. All 6,900,000 shares of common stock registered under the Registration Statement, which included 900,000 shares of common stock by an over-allotment option granted to the underwriters, were sold to the public at a price of $17.00 per share. All of the shares of common stock were sold by us and there were no selling shareholders in the offering. The offering did not terminate until after the sale of all of the securities registered by the Registration Statement.

The aggregate gross proceeds from the shares of common stock sold were $117.3 million. The aggregate net proceeds to us were $105.8 million after deducting $8.2 million in underwriting discounts and commissions and $3.3 million in other costs incurred in connection with the offering.

Of the aggregate net proceeds, $18.3 million was used to repay a subordinated loan and related prepayment penalty and accrued interest, and $17.3 million was used to pay cash to former cooperative members of Diamond Walnut Growers, Inc. in exchange for their membership interests. Approximately $45.2 million was used to repay borrowings under our short-term credit lines. We invested the balance of the net proceeds in investment grade, interest bearing instruments pending their use to fund working capital and capital expenditures.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

None.

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Item 6. Exhibits

     The following exhibits are filed as part of this report or are incorporated by reference to exhibits previously filed with the SEC.

		Filed with this	Incorporated by reference
Number	Exhibit Title	10-Q	Form	File No.	Date Filed
31.01	Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	X
31.02	Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	X
32.01	Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	X

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	DIAMOND FOODS, INC.
Date: June 7, 2006
	By:	/s/ Seth Halio
		Seth Halio
		Chief Financial Officer and
		duly authorized officer

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