Diamond Foods Has Good Upside, Kraft Healthy Too

In an earlier article, I explained why Kraft Foods (KFT) would benefit from its planned breakup. Since then, the stock has risen 13.6%, but is now rated a "hold" on the Street. Diamond Foods (DMND), which is specialized more in food processing, has risen nearly 30% over the last 30 day period and has recovered some of the lost value following its SEC debacle. Based on my multiples analysis and DCF model, I find strong upside in both Diamond and Kraft, but find the latter to be a safer investment.

From a multiples perspective, Diamond Food is the cheeper of the two. It trades at a respective 16.1x and 10.1x past and forward earnings, while Kraft trades at a respective 20.9x and 15.2x past and forward earnings. In addition, Kraft offers a dividend yield that is 250 bps higher at 3%. Both firms are rated a "hold" on the Street and have betas well below 1.

At the third quarter earnings call, Kraft's CEO noted solid performance:

Q3 was another strong quarter within a very challenging macro environment. We continue to have good momentum in all geographies on both the top and bottom lines. On the top line, consumers are responding favorably to our investments in new products and in better and more effective advertising. This has been a powerful combination. It's enabled us to take the necessary pricing to offset unprecedented increases in raw material costs, while delivering solid volume mix and market shares.

The ability to have volumes hold up well following price hikes in an uncertain economy is a testament to the strength of Kraft's brands. Operating income growth in the double-digits further establishes solid momentum going into the fourth quarter. Productivity, improvements in scale, and integration savings have contributed to even greater upside.

Consensus estimates for Kraft's EPS forecast that it will grow by 13% to $2.95 in 2012 and then by 19.3% and 10.8% more in the following two years. Assuming a multiple at the level of Diamond Foods and a conservative 2012 EPS of $3.43, the rough intrinsic value of the stock is $55.22, implying 51.1% upside.

Diamond Foods, however, is in a more precarious position given how the SEC is investigating for criminal fraud in financial practices. The audit review is expected to be completed around the middle of February and unusually high volatility will increase approaching that date. This, in my view, will only drive strong risk-adjusted returns. On January 24th, around 11K call optima were exchanged - more than triple what it is typical. Calls exceeded puts and the stock rose since speculation that activist investor David Einhorn eliminated his short position. Procter & Gamble (PG) states that it is hesitant about completing the $1.5B Pringles deal while Diamond Foods is being investigated.

Consensus estimates for Diamond Foods' EPS forecast that it will grow by 13% to $2.95 in 2012 and then by 19.3% and 10.8% more in the following two years. Modeling a CAGR of 14.3% for EPS over the next three years and then discounting backwards by a WACC of 9% yields a fair value figure of $49.38, implying around 35.1% upside. Assuming a multiple of 15x and a conservative 2012 EPS of $3.46, yields a similar result.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KFT over the next 72 hours.