Stockhouse Ticker Trax is equity specific research (Canadian listed and market cap < $300 million) published every Monday to paid subscribers. Our free Friday column may feature companies previously featured to paid subscribers (with a minimum one month delay) or discuss topics of interest to the general investment community and relevant to overall portfolio management.

I. Rockwell Diamonds (TSX: T.RDI, Stock Forum; 51 cents)

www.rockwelldiamonds.com

From the perspective of being unrecognized, very undervalued and offering strong growth potential over the next couple years, Rockwell remains one of my favourites.    

Below I have analyzed why, but also take a look at this corporate presentation Rockwell did in October as it is very insightful.

http://www.rockwelldiamonds.com/i/rdi/PPT-October2011.pdf

http://www.rockwelldiamonds.com/i/rcw/2011-11_CorporateUpdatePresentation.pdf  (Nov/11)

Recently Rockwell announced the sale of an investment diamond in Hong Kong that originated from their Saxendrift mine in South Africa. This sale at a Christie’s Auction clearly demonstrates the continued strength of the market in Asia for diamonds. This was a 35-carat diamond that sold for $232,000 “per carat!”

I personally cannot afford to be buying diamonds at Christie’s for investment purposes. Instead I prefer to buy the source of those diamonds and do so at what I feel is a dramatic discount to fair value. This allows me to participate in the industry and (hopefully) benefit from the capital appreciation of Rockwell’s stock as the diamond demand side remains strong.

Valuation gap:

Near the bottom of this recent market decline, Rockwell closed a $7.8 million financing at 75 cents (50% premium to its market price). A large portion went to its polishing and distribution partner, who is also a global leader in the diamond industry (Steinmetz). In addition they sold $6.5 million worth of equipment that was underutilized. Rockwell initially planned to raise up to $30 million but decided instead to modify its short-term capital budget - which limited shareholder dilution (a very professional approach).

The current market cap of $22 million offers tremendous opportunity given the fact they already had good working capital and minimal debt. With this financing and asset sale they raised $14 million, yet the market value in relation to their plant, equipment, and diamond reserves is dramatically discounted.

Net Book Value of Property, Processing Plant, Facilities & Equipment: $87 million.  

The difference between Rockwell’s working capital and its market cap is in the range of $10 million. This means the market values Rockwell as though all their equipment and diamond reserves are worth no more than the $10 million. This borders on the ridiculous. The company in the year ending Feb 11 generated $42 million in diamond sales and cash flow of $8 million.

Consider the $10 million valuation in relation to the following reports prepared this summer (disclosed in a news release):

1) Total Projects Value per 3rd Party Evans & Evans discounted cash flow method: $125 million

2) Total Projects Value per May 2011 Internal Economic Assessment: Avg $139 million

3) Internal Economic Assessment using Escalated Diamond Pricing:  $363 million

Rockwell owns 14 prospecting rights comprising about 30,000 hectares of alluvial diamond potential in South Africa. They are focused on increasing production to 10,000 carats per month within five years. Current production of some 2,500 carats of large gem quality diamonds per month is derived from two operations, the Holpan/Klipdam mine and the Saxendrift mine - both in South Africa.   

Industry outlook

With the exception of the occasional hiccup, gem quality diamond sales have remained strong across Asia, the United States, Europe and the Middle East. There was some slowdown during summer and with the market meltdown, but overall demand was surprisingly healthy. Whether or not problems in Europe are easily resolved in 2012, there seems to be a decent amount of optimism building back into the markets because of oversold conditions on the mid and large caps.

“Diamond demand will grow more than six per cent per year through 2020, far outpacing the 2.8 per cent annual supply growth, a report has said. A doubling in the ranks of the Chinese and Indian middle classes by 2020 will drive much of the demand surge, with their combined market share projected to reach 30 per cent by the end of the decade, up nearly half from its current levels and nearly equal to the share of the U.S.," said the 2011 Global Diamond Industry Report released by Bain & Company.” [India Times, Dec 22, 2011]

This is very encouraging for future sales of Rockwell's diamonds but even if diamond sales stabilized (vs. forecasted growth), it does not change the market valuation of Rockwell versus their underlying asset value and earnings power.

Tirisano

In October Rockwell closed on itsTirisano Mine acquisition. This property was on care and maintenance since 2008, and the acquisition involved substantial red tape. In addition to government approvals, they needed approval of the local Mogopa community and will work with them in partnership as the project is expected to generate almost 200 full time jobs.

Over the next six months they will optimize mining and plant efficiencies with initial processing targets of 90,000 cubic metres of gravels per month. The quality and price per carat of the stones recovered at Tirisano during the commissioning and recovery testing phase exceeded what was achieved by the mine's previous operators (Etruscan Resources) and an operational update this past week disclosed they are currently averaging $783 per carat.

Rockwell established a mining fleet, processing plant and final recovery capacity on site over the past 18 months to progress to commercial production. Plant modifications were completed in-house, using unused existing plant and machinery, which was redeployed from Rockwell's Wouterspan and other Northern Cape mines.   

Production goals and objectives remain the same at their other mines - Tirisano complements these.

Conclusion

Much like the comments I have made recently, it is amazing in a weak market how dramatically wrong the valuations can be on these small companies – and Rockwell is no different. In fact, the market valuation gap in the 40-cent and 50-cent range in relation to underlying asset values and future earnings potential is dramatic.   

Often these values and share prices make little to no sense. Worse so for the micro caps, which often have little following, are misunderstood, or are just victims of a poor market.

To assess risk with a company like Rockwell, I sometimes view them as private companies. If I pulled out the cash or working capital, would I sell my company for the remaining $10 million market valuation it currently has?  I would have to be insane when you consider the assets.

That doesn't mean to say you don't have to wait around for other investors to recognize the value (or maybe even a buyout), but with a long-term perspective on some of these small companies, the returns can be tremendous - and with stocks like Rockwell you can still sleep at night if you can get them for a good price.

Liquidity can be tight at times on Rockwell but this past month there has been steady selling in the low or mid 50-cent range. However, now that tax loss selling pressure is done I am unsure how long we will see paper available in this current range.

If all production targets are hit throughout 2012 and 2013 (and diamond prices remain this high), fair value should be at least $2 to $3 per share.

Disclosure: Danny Deadlock owns 50,000 shares of Rockwell Diamonds (TSX: T.RDI) purchased throughout 2011.