RIO OSO, California (Reuters) - It was a proud moment for the Kafkares family when they first hung the Diamond Walnut Growers sign in their orchard more than a decade ago.
People across this rolling stretch of northern California loved that red diamond logo: the symbol of a century-old agricultural icon, whose crop has long been an ingredient favored by holiday bakers.
Now, the family is tearing down the sign in disgust. So are their neighbors.
An accounting scandal over payments made by Diamond Foods Inc DMND.O to its growers -- as well as concerns that Diamond may have been paying below-market prices for their crops -- has hurt their confidence in the company, the largest U.S. walnut processor.
That relationship had already been strained in recent years as Diamond, a walnut farmer-owned cooperative until it became a publicly traded company in 2005, sought to become a diverse snack foods company.
The company's once dominant position in the walnut industry is eroding as farmers flee Diamond's ranks, according to court filings, company documents seen by Reuters, and interviews with more than 25 growers and some former Diamond executives.
Exactly how many farmers have left Diamond in recent months in unclear, but all of the growers spoken to for this story had either recently left the Diamond fold or were considering doing so, because they expect to get higher or more stable payments from the company's rivals.
Diamond declined to comment or allow its executives to be interviewed, saying its agreements with its walnut growers are confidential.
Walnut growers' concerns that they may have been getting below market prices as a result of Diamond's accounting and payment practices have made them ripe targets for rivals from China and elsewhere.
"You see that Diamond sign up front and you think, 'OK, pull in there,'" said Manuel Tavares, a California-based grower representative for Turkish walnut importer Turkhan Foods. "It's easy pickings."
The arrival of more traders and processors is fueled by rapidly growing consumer demand worldwide for American-grown walnuts, particularly in China.
The U.S. Department of Agriculture tallied 2011 as the biggest export year in the industry's history, with $1 billion worth of walnuts sold and shipped overseas, up from $321 million in 2005 when Diamond went public. Last year more than $218 million of walnuts went to China and Hong Kong, compared with $6.6 million in 2005.
The speed of the growth -- walnuts are now California's fourth-biggest export behind almonds, dairy products and wine -- has reshaped the U.S. walnut industry into an increasingly competitive and transparent market.
Gone are the days when farmers would shy away from asking how much a neighbor was being paid. Gone, too, is the tradition of staying loyal to a processor that families had sold their crops to for generations.
"Growers are hedging their bets," said Mike Poindexter, whose family operates a rival processing plant in Selma, California.
The accounting scandal has resulted in the ouster of Diamond Chief Executive Michael Mendes and Chief Financial Officer Steven Neil. Diamond is also restating its financial results for two years and had to abandon plans to acquire the Pringles potato chip brand from Procter & Gamble Co.
Diamond said on February 8 its audit committee had discovered a payments of $20 million to walnut growers in August 2010 and $60 million in September 2011 that were not booked in the correct periods. By delaying such costs, Diamond likely boosted its earnings in the years concerned.
Mendes told Wall Street analysts last fall the money in one year was a pre-payment for nuts that had yet to be delivered. But when farmers contacted Diamond, company employees said the money was for walnuts delivered the previous year.
"I was told, point blank, by an employee that I was thinking like a farmer and didn't understand accounting," said Doug Barnhill, a Diamond walnut grower in Oakdale, California, who is also a certified public accountant. "The rest of that phone call was not pleasant."
Diamond is facing an investigation by securities regulators, the company disclosed in a regulatory filing. It is also being probed by federal prosecutors, according to sources familiar with the matter.
Mendes' attorney declined to comment. Neil's attorney could not be reached for comment.
Diamond was also rocked last fall, when one of its directors committed suicide. It said the death was not connected to the accounting problems.
Under the terms of their contracts, Diamond's farmers received partial payment when they delivered their crop to the company last fall, with the final price to be determined later this year. Now farmers are worried that Diamond will be strapped for cash and may not be able to pay competitive prices.
Diamond faces a shareholder lawsuits that are likely to prove distracting and possibly costly, in addition to the probes by securities regulators and federal prosecutors.
The company's restatement of earnings could also put it in breach of its debt covenants, which would likely lead to a renegotiation of debt agreements and higher interest payments -- a particular concern given that Diamond borrowed heavily to make acquisitions.
"There's a lot of uncertainty right now," said Matthew Conant, a walnut grower and district director of the California Farm Bureau Federation.
Meanwhile, Diamond has missed out on most of the growth in Chinese demand, the result of a decision under Mendes years ago to transform Diamond into a major U.S. snack food maker.
When it went public in 2005, Diamond depended on walnuts for 70 percent of net sales. At the time, Mendes' plan was to move the company out of the commodities business of selling nuts in their shells, which he called the "trash nut market," say growers and one former cooperative official who knew Mendes.
His dream was to use acquisitions to transform Diamond into one of the biggest snack food manufacturers in the world, while continuing to sell its Emerald-branded nuts and vie against Planters, the snack nut market giant.
In discussions with company officials at the time, farmers say, Diamond said it wanted to diversify and reduce its reliance on walnuts.
Mendes steered Diamond through the $190 million acquisition of Pop Secret microwave popcorn in 2008 and bought Kettle Foods potato chips for $615 million in 2010.
While Mendes turned to packaged snacks, the market for walnuts took off.
Around 2008, China's demand for nuts -- from almonds and pistachios to walnuts -- began to soar as Chinese incomes grew. Demand has outstripped domestic supply and Chinese consumers typically judge U.S. nuts to be of a higher quality than those from China.
Diamond didn't adjust.
Its walnut business mainly focused on the premium U.S. market for shelled nuts ready for snacking or baking. The only problem: U.S. demand for shelled nuts has either stayed flat or fallen in recent years.
By contrast, the Chinese are mainly after nuts that are still in their shells, leaving processors asking why they should go to the expense of picking apart walnuts when there's a booming market for nuts whose shells have not been removed.
As a result of its strategy, Diamond's international business steadily shrank as a percentage of the company's net sales, and Diamond's presence in the Chinese and other overseas commodities markets has become marginal at best, according to public filings and sources familiar with the company's operations.
Certainly its growth in the U.S. snack foods business has been strong, helping to lift net profit more than six-fold during fiscal years 2007 to 2011. But the nature of the accounting problems means those figures may well be in doubt.
Diamond's competition, meanwhile, has been building. In 2009, fifty-nine companies in California processed or marketed walnuts. Today, the number is 81, with most of the newcomers focusing on the international market.
For the most part, the imported tree nut business in China is dominated by traders and importers from the Pearl River Delta in southern China, who rely on brokers in Hong Kong to help them source product, say industry watchers.
Great Favour International Ltd, Hong Kong Ever Bright Development Co and On Tak Lung Ltd are among those that have approached California walnut farmers in the past, and are now looking to snap up this year's crop for export to China and elsewhere, said R.L. "Pete" Turner, who runs an agricultural consulting firm in Stockton, California, and also farms walnuts.
Some of the farmers they've approached previously supplied Diamond, according to Turner and a source at a rival processor.
Walnuts account for 30 percent of Great Favour International's business, according to a company spokeswoman. It mainly imports walnuts from the United States and may try to acquire more, depending on market conditions, she said.
A spokeswoman for On Tak Lung said it is importing walnuts from the United States, though its main business is in almonds, with only 20 percent of its trade in walnuts. She said that she hadn't heard of Diamond. Hong Kong Ever Bright Development could not be reached for comment.
At least one group of Chinese buyers decided to set up shop closer to the source and launched BHK Nut Corp last year. The company runs a custom walnut processing center in Orosi, California, a hamlet 150 miles southeast of Diamond's processing plant in Stockton. Chris Yu, president of BHK Nut, did not return several calls for comment.
Farmers say the price offered by Diamond's domestic and overseas rivals for premium nuts beats what Diamond offered in recent years by at least 30 percent, and in some cases as much as 100 percent.
The struggle has become so intense that some rivals have been encouraging growers to pull out of their contracts with Diamond early, according to the farmers.
"I've had someone offer to back up a truck at harvest and take all the nuts," said Manuel Kafkares, the farmer in Rio Oso who owns a 40-acre orchard.
Kafkares said no. But after 14 years with Diamond, he and his family have let their contract lapse. The Kafkares have decided to go with rival John B. Sanfilippo & Son, owner of the Fisher nut brand, saying the scandal has raised doubts that Diamond will be able to recover and pay them competitive prices.
Complaints by growers about payments from Diamond are not new. They began to swirl in 2005, soon after the company went public. In 2008, a group of former members of the pre-IPO cooperative filed a class-action lawsuit in San Joaquin County against Diamond. The plaintiffs argued, among other things, that the company had breached its contract by paying them at below fair market value for their 2005 and 2006 walnut crops, according to the complaint.
A state appellate court ultimately sided with Diamond. The company is currently suing more than 40 farmers for nearly $1.2 million in attorney's fees.
The company declined to comment on the lawsuit.
Given this tension, some farmers say the recent accounting scandal only fueled their eagerness to leave.
While there are a number of large growers, the majority of the state's more than 5,700 walnut farmers do not own a lot of land. Walnut farms in California, on average, are 46.3 acres, according to the U.S. Department of Agriculture's 2007 census.
When the company went public in 2005, Diamond had at least 1,600 growers under contract, who produced about 50 percent of the walnuts grown in California, according to court documents and some former Diamond farmers. Last fall, as the accounting scandal was coming to light, Diamond had about 1,000 farmers under contract and controlled approximately 20 percent of the market.
Whether Diamond will be able to recover from its current troubles and rebuild its business is unclear. Either way, it's going to be very expensive -- both in cash and in credibility -- for the company to remain a major player in the walnut business, according to industry experts and rival processors.
The grower community's reaction to the scandal hasn't been pretty either. At the World Ag Expo in Tulare, California, in February, the Diamond Foods booth sat abandoned. A rival joked about putting up a photograph of the Titanic in the empty space. One man walked up to the spot, turned and spat on it, before walking away.
The company's interim management team is trying to stem the bleeding.
Late last month, the company said it would pay retention bonuses to key senior executives, according to a regulatory filing. A week earlier, interim CEO Rick Wolford met with growers behind closed doors at the Silverado Resort and Spa in Napa Valley, promising to pay more competitive prices in the future, according to sources familiar with these meetings.
For farmer John Taresh, who did not attend these meetings, such promises come too late. Taresh, whose family has sold walnuts to the company since the 1940s, recently wrote to Diamond to break the family's contract a year early. The scandal had damaged his trust in the company.
He said he called Diamond to let it know -- and give the company a last chance to change his mind.
The company, he said, never called him back.
Reporting By P.J. Huffstutter; Additional reporting by Nanette Byrnes, Mihir Dalal, Twinnie Siu and Dan Levine; Editing by Brad Dorfman, Martin Howell and Steve Orlofsky