Suraj Srinivasan and Research Associate

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Professor Suraj Srinivasan and Research Associate Tim Gray prepared this case with assistance from Research Associate Jordan Smith. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources o f primary data, or illustrations of effective or ineffective management. Copyright © 2013 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.



Diamond Foods, Inc.

When the phone rang in September 2011, Mark Roberts wasn’t thinking about walnuts. But walnuts were what his caller wanted to discuss—that and a company called Diamond Foods, a San Francisco-based purveyor of nuts and other snack foods.1

The caller wouldn’t say who he was, and he insisted that this would be the only time he and Roberts would speak. He said that Diamond had sent a large payment to each of its contract walnut growers accompanied by a letter. The letter said the growers were receiving momentum payments toward their 2011 harvests. The caller didn’t know what a momentum payment was, and he wouldn’t hand over the letter. But he did know this: some farmers were angry at Diamond, believing that it had been underpaying them for their walnuts for several years. It had signed them to multiyear contracts, promising cooperation. Now, the farmers believed, it was squeezing them.

Roberts, founder of Off Wall Street Consulting Group, an investment research company in Cambridge, Mass., didn’t usually base his reports on anonymous tips, especially ones involving companies that were in the middle of acquisitions, like Diamond. Just a few months before, Diamond had announced plans to purchase the Pringles potato-crisp brand from Procter & Gamble for $2.35 billion. The deal hadn’t closed, and that made Roberts wary. Acquisitions were messy; they clouded financial reports. You never knew exactly what the resulting company would look like or whether promised efficiencies would arise. A clear view of accounting mattered a lot to Roberts, who made short-sale and stock-purchase recommendations to hedge funds and other large investors. He wouldn’t publish a recommendation unless he could nail down his views with robust analysis.

Roberts cherished his credibility. In the 21 years since he’d started Off Wall Street, he’d earned a reputation as one of the more prescient stock analysts around, thanks to such recommendations as his 2001 short call on Enron, the Texas energy-services company that collapsed in a massive accounting fraud. His firm didn’t make a lot of recommendations in a year—typically only 20 to 25—so Roberts had to be confident when it did. That caution paid off: Off Wall Street had been right 80% percent of the time. Roberts didn’t want that to change—he didn’t want to squander his firm’s reputation or waste his time on a fool’s errand.

But the Diamond tipster had provided so much detail that Roberts felt compelled to investigate. He hadn’t heard of a momentum payment, either. That piqued his curiosity. Why, he wondered, would a public company need to invent a new financial term?

Before he could do anything else, he had to get a copy of that letter.

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113-055 Diamond Foods, Inc.


Diamond in the Rough

For most of its life, Diamond Foods wasn’t a company. It was a cooperative. California walnut farmers had created it in 1912. They had figured that, by banding together, they would have more leverage in negotiating with buyers and greater heft in marketing their nuts. They based the name of their brand on the most precious of stones, and that was no accident. They adhered to a strict quality standard—nuts that weren’t plump or pretty enough couldn’t be marketed under the name. Within a few years, they also started a nationwide advertising campaign—the first of its kind for a nut. By the 1950s, they’d opened a headquarters office in Stockton, Calif., about two hours east of San Francisco.2

California walnuts were high quality, bigger and meatier than those from elsewhere. They were first cultivated in the late 1700s by Franciscan missionaries. Commercial growing began about a century later. The state’s walnut farms came to be centered in the northern section of the Central Valley, a 400-mile-long swath of verdant farmland wedged between California’s coastal mountains and the Sierra Nevada range. In 2012, the valley accounted for “99 percent of the commercial U.S. supply and three-quarters of world trade,” according to the California Walnut Association.3 That same year, California had about 4,500 walnut growers. Their annual harvest stretched from late August through late November.

For decades, consumers could find Diamond’s nuts in the baking sections at groceries in canisters marked with a red diamond-shaped logo. The nuts were sold as a cooking ingredient—a compliment to cookies, brownies, salads and stuffing.

By the 1990s, consumer tastes had begun to change, and U.S. walnut demand was slackening, even as supply increased. Walnuts hadn’t yet gotten a boost as a heart-healthy food—research showing the benefits of their omega-3 fatty acids wouldn’t become popular until the next decade— yet farmers had planted more trees, and harvests had grown. Diamond was selling some of its surplus abroad but not enough to prevent falling prices. The cooperative had to find new customers and shed its old-fashioned ways.

A Suit Enters a Blue-Jean Business

The CEO chosen to lead the push into new markets was Michael J. Mendes. Only 33 years old when he became boss, Mendes boasted the kind of self-made résumé that a businessperson might brag about. His parents had immigrated to the United States from the Azores, a Portuguese archipelago in the middle of the Atlantic Ocean. He’d grown up in Oakdale, Calif., a farming town not far from Stockton. He’d earned his bachelor’s at California Polytechnic State University-San Luis Obispo and his master’s in business at the University of California Los Angeles.4 After college, Mendes did a stint with Dole Foods and then joined Diamond in 1991 as vice president of sales and marketing. He made his ambitions plain from the start: in a boots-and-blue-jeans business, he showed up for work every day in a suit.

Within six years, he was CEO, and he put his marketing savvy to work to try to revive the cooperative’s flagging fortunes. He expanded the culinary line, adding other nut varieties and pushing the company into the leading position in that segment of the market.

He also saw promise in a place where Diamond hadn’t much competed—snacks. The sector was estimated to be three times as large as culinary nuts. But it was also mature and dominated by a single big player, the Planter’s division of Kraft Foods. Planter’s had a market share of about 40%,

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Diamond Foods, Inc. 113-055


and Kraft appeared to have gotten complacent.5 The iconic emblem of the product line, Mr. Peanut, had existed for nearly a century. Still sporting a monocle and a top hat, he’d gone stale.

Mendes saw a chance to appeal to younger consumers. They weren’t committed to any particular brand or to nuts at all. And they liked to snack on the go, as they hustled to work or scurried to class. To lure them to Diamond, Mendes led the creation of the Emerald line of nuts and nut-and-dried- fruit mixes. The Emerald offerings came in a slim green canister that fit easily into an automobile cup holder, backpack pocket or purse. Diamond introduced the line with a cheeky ad campaign that played off its E.N. initials. TV spots featured “Envious Nomads,” “Enterprising Norwegians” and “Exercising Newscasters.” The ad campaign would culminate in 2005 with a 30-second spot during the Super Bowl.

Emerald took off, helping to boost Diamond’s revenue. For fiscal 2004, the cooperative reported net sales of $360 million, a 14% jump over the prior year.

Cracking a New Nut

Mendes’s ambitions weren’t limited to raising nut sales. He wanted to move from the farm to the financial district. He began lobbying his farmer-members to support the conversion of Diamond from a grower-controlled cooperative into a publicly traded company.

His persuasion worked. In 2005, more than 80% of the members voted for the conversion, and Diamond became a public company. As part of the transaction, the members could choose to receive either stock in the new company or cash. Thus Diamond Foods issued about 6.7 million shares of stock to the former members as part of an initial public offering. Members also received cash payments to compensate them for working capital tied up in the cooperative. The combination of the stock and the cash meant that farmers collected about $120 million in the conversion. As stockholders, they would also be entitled to stock dividends. The new Diamond also sold stock to the public, raising about $150 million. It used some of the proceeds to pay off debt and kept some to develop new products and acquire equipment.6

The conversion changed the governance of the enterprise. Diamond went from having a board of farmer-members to having one where the former cooperative was represented by only three of the nine seats. (See Exhibit 1 for biographies of the board members in 2011.) The farmers also became suppliers to a company, rather than members of a cooperative. They were offered contracts enabling them to continue to sell their walnuts to Diamond. A contract could last three, five or 10 years—the farmer could choose—and 95% of growers opted for one.7 Under the contracts, Diamond would buy their entire crop. The company then had the right, after each year’s harvest, to set the price it would pay for the nuts, based on spot prices, quality and other factors. The farmers received no price guarantees. Payments came in installments, and the final one wouldn’t arrive until after the harvest. Thus for, say, the 2010 harvest, which would’ve stretched from August through November of 2010, the first payment would be in November 2010, but the bulk of the payments would be made between March 2011 and August 2011. Diamond was also free to source walnuts abroad, as it was already doing with hazelnuts, pecans and pine nuts.

The following year, Diamond made an announcement that augured expansion beyond the groves of California’s Central Valley. That May, the company said it was paying $18 million for assets of Harmony Foods. As part of the deal, it acquired a plant in Fishers, Indiana, which produced trail mixes, dried fruits and other sweet snacks. Just a few months later, Diamond issued its annual financial report—its first full-year statement as a public company. It reported net sales of $477 million

This document is authorized for use only in CHRIS OSADCZUK’s AC465_Advanced Forensic Accounting_2_12_2019 at Kaplan Higher Education from Aug 2018 to Feb 2019.



113-055 Diamond Foods, Inc.


and cost of sales of $412 million for fiscal 2006. Its gross margin percentage was 14.3, and its diluted earnings per share were $0.47.8 (See Exhibit 2a for Diamond’s income statements, Exhibit 2b for balance sheets and Exhibit 2c for cash flow statements.)

Not all farmers were pleased with the new direction. In 2007, a group of 42 of them formed a coalition called the Growers Committee for a Fair Price from Diamond and complained that the company had underpaid farmers by more than $20 million for the 2005 harvest and nearly $30 million for the 2006 harvest.9 Diamond responded by pointing out that the two years had yielded record harvests and that it had paid the highest price per acre of walnuts in the country’s history. It also noted that the complainers were a tiny minority of its walnut growers. When the company released its financial report for fiscal 2007, net sales continued to climb, reaching $523 million. Cost of sales rose to $444 million, while gross margin percentage hit 15 and earnings per share, $0.53.

Growth through Acquisitions

The next year brought another acquisition—and a declaration that that Diamond was expanding into the broader and potentially more profitable snack market. In August 2008, the company purchased the Pop Secret brand from General Mills for $190 million in cash. Pop Secret was the second largest brand of microwave popcorn, behind ConAgra’s Orville Redenbacher, and it had a 25 percent share in U.S. groceries.10 Mendes said the acquisition would “significantly broaden our presence in the snack aisle.”11 A larger footprint in the snack aisle brought opportunities for cross promotions and also gave Diamond greater leverage in dealing with grocery buyers, as the same buyer would typically handle both popcorn and nuts. What’s more, Diamond’s introduction of Emerald had given the company and its CEO reputations as innovators in terms of marketing. Several analysts speculated in their briefs analyzing the acquisition that Diamond would be able to revive a brand that had been neglected by General Mills because it didn’t dovetail with the company’s other offerings.

The deal brought Diamond into direct competition with some of the biggest companies in world, including PepsiCo, via its Frito-Lay division. Frito-Lay dominated the snack sector, controlling nearly half of the market and selling such well-known brands as Lay’s, Doritos and Cracker Jack. In 2008, Frito-Lay also introduced a line of nuts and nut snacks called TrueNorth. The other major players in the industry—ConAgra, General Mills, Kraft Foods—each had a share of about 5%, compared with Diamond’s share of 2%.12

In an interview with Investors Business Daily, Mendes explained the thinking behind the acquisition and his company’s move into the broader snack market.13 Like nuts, popcorn was a mature snack category with stable sales, but Diamond aimed to revive the category, as it had done with nuts, by introducing new flavors, more appealing packaging and grabbier advertising, Mendes said. “We believe we can be additive to the microwave popcorn category in a similar way we were to the snack nut category,” he said. On top of this, popcorn complemented Diamond’s nut offerings, providing potential efficiencies. Popcorn was typically sold in the same section of grocery stores as snack nuts, and the same retail buyer would usually handle both types of products. Both products also had long shelf lives and didn’t require refrigeration. “There’s a big opportunity to regrow the [popcorn] category with some marketing dollars and product improvement,” an analyst told Investors Business Daily.14

Even with the Pop Secret acquisition, Diamond was still small, but its moves were beginning to win more attention from investors. Throughout much of 2009, its share price climbed. The stock began the year at about $20 a share, just a few dollars above the offering price, and closed it at about

This document is authorized for use only in CHRIS OSADCZUK’s AC465_Advanced Forensic Accounting_2_12_2019 at Kaplan Higher Education from Aug 2018 to Feb 2019.



Diamond Foods, Inc. 113-055


$35 a share. Its trailing price-earnings (P/E) ratio for the year reached 21, compared with an average of 18.6 for the S&P 500.

Earnings were rising, too. In fiscal 2008, net sales grew to $532 million, while cost of sales reached $443 million, giving Diamond a gross profit percentage of 16.6. In fiscal 2009, net sales kept climbing, to $571 million, but cost of sales fell to $435 million. Diamond’s gross profit percentage swelled to 23.7. The financial reports also indicated that the acquisitions had remade Diamond’s product mix. In fiscal 2008, culinary nuts still accounted for the bulk of the company’s revenue. But by the following year, snack sales surged—if they continued their trajectory, they’d soon match, even outstrip, culinary sales.

In February 2010, Diamond made a move that pushed snacks to the forefront of its business. It announced that it was buying Kettle Foods, a potato chip maker, from Lion Capital for $615 million in cash. The purchase included two Kettle Foods plants in the United States and one in the United Kingdom. As with Pop Secret, Kettle Foods stood to make Diamond an even more formidable competitor in snacks. The deal, which was to close at the end of the following month, would double the size of Diamond’s snack business. Also like the Pop Secret acquisition, it offered opportunities for cross promotions and further bulked up Diamond’s muscle in the snack aisle. And the burlier Diamond became, the more it could demand good positioning for its products on store shelves. Potato chips also offered a new sort of distributional efficiency to Diamond: they were bulky but light, which meant that they complimented heavy, but less bulky, nuts. A truck carrying nut snacks to a supermarket might have plenty of room left for lightweight chips.

Diamond said it would fund the purchase with a combination of cash reserves, debt and new equity. It soon did a stock offering that raised $181 million. It also took on two large new loans—$200 million revolving-credit agreement and a $400 million term credit agreement. It said that it would draw on $170 million of the revolving loan and the entire term loan to help pay for Kettle and pay off existing debt. The loans came with covenants requiring that Diamond maintain a maximum consolidated leverage ratio of not more than 4.75 to 1. The covenants required that that ratio decline annually to reach 3.25 to 1 by the end of April 2014, and they mandated a minimum fixed-charge coverage ratio of 1.1 to 1 through October 2012. (See Exhibit 3 for Diamond’s debt covenants.)

When Diamond released its fiscal 2010 earnings a few months later, it looked like a different company. Snack sales—now $321 million—outweighed culinary sales of $218 million. “For 2010, our snack sales grew 70 percent,” Mendes said.15 He projected that they would rise to $540 million in fiscal 2011—or “25 times larger than when we went public in 2005.” (See Exhibit 4 for Diamond segment sales information.) Mendes added a cautionary note, saying that developments in the walnut industry might affect the coming year’s earnings. “The 2010 California tree nut crop is projected to be the largest in history but will be harvested much later than normal,” he said. That could change the timing of the company’s revenue, pushing sales later in the year, he said.

All the while, Diamond’s stock price kept climbing. By the end of 2010, it had reached about $55 a share from the IPO offer price of $17.50. Diamond’s P/E rose to 42, when the average P/E of the S&P 500 was to 15.5. (See Exhibit 5 for Diamond stock-price performance since its IPO.)

Not all investors were swayed by Diamond’s move into snacks. The company’s stock price wasn’t the only thing rising: short-seller interest was increasing, too. It began to tick up in the second half of calendar 2009 and remained elevated. (See Exhibit 6 for the quarterly percentage of short interest in Diamond.) The “shorts” might have noticed that Diamond’s snack business was unproven and that the company’s accounting for it was opaque. Diamond didn’t break out the profitability of its various segments, only their total sales. What’s more, as a snack company, Diamond was a Lilliputian among

This document is authorized for use only in CHRIS OSADCZUK’s AC465_Advanced Forensic Accounting_2_12_2019 at Kaplan Higher Education from Aug 2018 to Feb 2019.



113-055 Diamond Foods, Inc.


leviathans: it paled next to outfits like Frito-Lay and Kraft. A new entrant like Diamond would probably have to take share from these incumbents, and they might use their financial heft to fight back. The short sellers might have noticed, too, that Diamond’s acquisitions had brought a growing slug of debt to its balance sheet. The company would have to produce enough cash to service that debt in good times and bad. Much of the debt carried floating interest rates. If market rates rose, Diamond could find its cash flows squeezed.

If the Kettle acquisition decisively turned Diamond from nut merchant to snack foods company, then its announcement in April 2011 of its plans to acquire Pringles made clear that the company aimed to compete head to head with the likes of Frito-Lay. Pringles was an iconic snack brand, known for its uniquely shaped potato crisps. Their saddle shape, called a hyperbolic paraboloid by mathematicians, was created partly to facilitate packaging. It enabled the crisps to be stacked one atop another in tubular canisters.16 The shape became so identified with the crisps that a velodrome built in London for the 2012 Olympics with a roofline of the same shape would be nicknamed “the Pringle.”17

The Pringles acquisition was like a chipmunk trying to munch a walnut in one big bite. Everything about it was large, from the price tag—$2.35 billion—to the amount of debt that Diamond would assume from Procter & Gamble—$850 million. Diamond said that the deal would triple the size of its snack business.18

The deal wasn’t just hefty. It was also knotty. Rather than buying Pringles outright, Diamond agreed to acquire it through a Reverse Morris Trust, which provided tax benefits for P&G’s shareholders. P&G would split off Pringles into a new entity, which would then merge with Diamond. P&G’s shareholders could choose whether they wanted to participate. Those who did would exchange their P&G shares for Diamond shares. Diamond predicted that it would incur one- time merger-related costs of $100 million over the two years following the transaction. Its shareholders would be left with 43 percent of the resulting company. (See Exhibit 7 for Pringles deal pricing and Exhibit 8 for Pringles financials.)

In a news release announcing the deal, Mendes said: “Pringles is an iconic, billion dollar snack brand with significant global manufacturing and supply chain infrastructure. Our plan is to build upon the brand equity Pringles has established in over 140 countries. This strategic combination will create an independent, global leader in the snack industry…”19

Stock analysts echoed Mendes’s enthusiasm, recommending that investors buy the stock and highlighting its potential to contribute to Diamond’s continued growth. One analyst’s report called attention to the Diamond management team’s “proven ability to create and grow brands with imaginative marketing and product innovation.”20 Another argued that integrating Pringles into Diamond’s snack lineup would make the company’s earnings more stable and that that stability would appeal to even more investors. That report also pointed out that Diamond was more focused on snacks than was Procter & Gamble, a multinational with dozens of brands in multiple consumer categories. “This greater focus could bring with it higher sales growth in the years to come,” the report said.21 A few analysts suggested that Procter & Gamble had let Pringles languish, failing to invest enough money in refreshing the brand’s marketing and product innovation. Pringles had a few flavors—all of them could have fit into a single grocery bag—but nothing to rival the dozens of options offered by Frito-Lay. Diamond wouldn’t become a giant multinational with one acquisition, but it could use Pringles as a platform to introduce all sorts of savory snacks.

Investors appeared to cheer the transaction. Over the weeks that followed, Diamond’s stock climbed, and it mostly continued climbing throughout the summer. That September, Diamond

This document is authorized for use only in CHRIS OSADCZUK’s AC465_Advanced Forensic Accounting_2_12_2019 at Kaplan Higher Education from Aug 2018 to Feb 2019.



Diamond Foods, Inc. 113-055


reported record earnings for the 2011 fiscal year. Net sales swelled to $966 million, including snack sales of $553 million.22 Cost of sales grew to $715 million, giving the company a gross margin percentage of 26. Earnings were $50 million, or $2.22 a share, and included $16.8 million worth of integration and acquisition costs related to the Kettle and Pringles deals. “We’re particularly pleased that we could achieve such strong performance while effectively managing the Pringles integration,” Mendes said.23

The Pringle’s deal caught the attention of a popular stock commentator—Jim Cramer, host of CNBC’s Mad Money. On Sept. 16, 2011, Cramer featured Diamond on his show, interviewing Mendes on the air.24 Cramer urged his viewers to buy “high quality, best-of-breed companies,” like Diamond. He called Diamond’s acquisition of Pringle’s “brilliant” and applauded the company for building its brand by investing in advertising. “Diamond may have a whole new leg of growth ahead of it thanks to this Pringle’s buy,” he said. “This major brand may have been lost in the crowd at P&G. It’s now getting the full attention it needs.”25

Investors seemed just as enthusiastic as Cramer. That September, Diamond’s stock hit its high up to that point—$92.47 a share. The market, in effect, was applauding for Mendes’s deals and counting on further growth.

Gumshoeing in the Groves

Within a few weeks of Diamond’s fiscal 2011 earnings announcement, Mark Roberts, of Off Wall Street, had sent an investigator to California to learn more about the momentum payments that his anonymous caller had reported. At his offices in Cambridge, just a few blocks from the buskers and bustle of Harvard Square, he and his analysts were also examining the economics of the walnut industry. They learned that demand for U.S. walnuts was growing abroad, particularly in China and Turkey. In 2006, fewer than 25 million pounds of walnuts had been shipped to China. By 2010, shipments had grown more than fourfold. Similarly, Turkey’s shipments had grown from a negligible amount in 2006 to more than 50 million pounds in 2010.26

Exports had to rise because, while Americans were eating more walnuts, they weren’t consuming enough to counterbalance increased production. California’s total production had grown for much of prior decade, reaching 500,000 short tons in 2010. Prices per ton had bounced up and down, with the increased demand and increased production pulling in different directions at different times. According to the U.S. Department of Agriculture, the price per ton of in-shell walnuts started the decade at about $1,100 and more than doubled by 2007, hitting $2,290 per ton. It sank the following year, dropping to $1,280 per ton, and then grew anew in 2009 and 2010, reaching $2,110.27

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