*** In our last Penny Sleuth, Angela Roberts told you
about the most profitable way to a girl’s heart — diamonds. Shortly after
Angela’s story hit your inbox, (http://www.pennysleuth.com/alertholder/03.25.05), I got a call from Carl (The GRIPPER) Waynberg who said that he
had a little-known, north-of-the-border angle on the diamond industry that would
even give Hell’s Angels the shizzle.

So rather than start with our customary news briefs,
outlooks and colloquium, I’m turning it over to Carl…

*** My colleague Angela Roberts deserves a thank you for
at long last putting that eternal question to bed. Yes, yes, yes…a thousand
times yes, a resounding, if not emasculating and shriveling yes: SIZE DOES
MATTER.

When it comes to diamonds, that is. (Whew!)

When it comes to the industry built around the coolest
kind of ice, well you might say it’s not just the size of the ship, but the
motion of the ocean. Underneath their eye appeal, diamonds have a nasty (read:
bloody) reputation. To the rescue: Canada.

“Canada? You’ve gotta be kidding!” As former Hope Diamond
owner Elizabeth Taylor once purred while shilling for White Diamonds perfume,
“Not so fast.”

True, it wasn’t so long ago — 1990, in fact — that there
was no such thing as a Canadian diamond industry. But a year later, all that
changed.  The discovery of diamonds in Canada’s rather brisk Northwest
Territories in 1991 was an early indication of a nascent transformation in
Canadian mining and the world diamond-mining scene.

Lac de Gras was the site of the initial discovery of
diamonds in Canada. The Lac de Gras find would become the Ekati mine, which is
operated by Dia Met Minerals and BHP Billiton. Three years later, a second
discovery was made at Diavik, now operated by Aber Diamond Corp. and Rio Tinto.

Those inclined to punning might say Canadian diamond
exploration is still an industry in the rough. After all, it’s entering only its
seventh year as a diamond player of any weight. But already it’s the world’s No.
3 diamond producer, behind Botswana and Russia. In 2002, Canadian mines produced
approximately five million carats. In 2003, Canadian
diamond production more than doubled to 11.2 million carats. In a
very short time, Canada has gone from a non-entity in the diamond biz to a
supplier of about 15% of the world’s rough diamonds. Today, nearly half of all
funding for diamond exploration goes to Canada.

Even more impressive than the huge growth itself is the
fact that the huge growth has come on the strength of just two active diamond
mines: Ekati and Diavik. Snap Lake, a joint venture between De Beers and
Winspear, is slated for full production in 2007. When it becomes active, it will
propel Canada passed Russia into the No. 2 spot — with just four

active mines.

As for the size-of-the-ship/motion-of-the-ocean
metaphor…Canada’s diamonds proudly stand up to competition in terms of size —
and they offer one crucial advantage over the competition: Unlike diamonds from
Angola, Liberia, and Sierra Leone, for instance — “blood diamonds” used by
evil-doers to finance political conflict — Canadian diamonds
are “clean.” Consumers’ preference for clean diamonds is one of the
reasons one major diamond retailer cut a deal with a junior miner to buy or
market all the diamonds a future Canadian mine produces.

Canadian law enforcement agencies are working hard to keep
the country’s diamonds clean. As it turns out, it’s not just consumers who
prefer their bling-bling blood-and-guts-free; four out of five and Hells Angels
agree: Canadian diamonds are the shizzle.

The robust growth of the country’s diamond industry, from
nobody to world’s third largest by value in a little more than a decade, has had
the anticipated moth-to-a-flame effect, attracting the attention of such
luminaries as the Hells Angels and Eastern European crime gangs.

The mining segment of the industry is, the thinking goes,
less vulnerable to infiltration by organized crime — at least for the time
being. Evidently, the leather-heavy heavies prefer balmier temps to the
sub-arctic conditions of the Northwest Territories, where most mining activity
is currently focused. But if they ever discover GORE-TEX, the Mounties will need
to be extra vigilant.

Post-mining industry segments, however, like cutting and
polishing, are more likely to attract unwanted attention, because Canada’s work
pool in these trades is already stretched thin. It’s also more likely that it
will be Eastern European crime groups who come a-courting, since they’re already
involved in various facets of the diamond industry
in other parts of the world. The Criminal Intelligence Service of
Canada, which in the past has warned about potential infiltration by Eastern
European street toughs, is also becoming increasingly concerned about outlaw
biker gangs. When organized (or disorganized) crime wants in on the action, you
know you’re on to something.

Ms. Roberts suggested some ways to play the diamond
industry. I’ll suggest one, to junior explorers. One point in particular is
worth noting: Dia Met, Aber and Winspear are all junior miners that have
partnered with seniors as a way to mitigate risk and transform themselves into
industry leaders. That’s the same trend that was evident among junior

gold explorers.

(Warning: Shameless Plug Ahead!)

A number of junior Canadian diamond explorers hope to make
that same transformation. Some of the names I’ll reveal to GRIPPERS in a few
weeks are already proving themselves important players on the relatively young
Canadian diamond scene.

(How’s that for dangling the carat?)

*** Thanks, Carl. If you folks would like to find out more
about The Grip’s winning microcap picks, visit www.the-gripper.com.

Next up, we discover a Silicon Valley innovator that’s
transforming the global cell phone market…

The Echo Killer

The year was 1985. Dr. Irwin Jacobs and Klein Gilhousen
were driving back to their office in San Diego from Los Angeles. They had just
come from an intriguing meeting with ace defense contractor Hughes Electronics.
The topic of discussion? The next big thing in satellite
communications.

Jacobs was an electronics genius and MIT alumnus. He had
already made millions from the sale of his first computer company. Gilhousen was
a crack inventor, with several key patents to his credit. Their startup,
QUALCOMM, had been retained by Hughes to tackle vital theoretical problems of
perfecting communication satellites for phone calls.

Cruising southbound on I-95, both men struggled with a
thorny question: How do you make satellite phones more efficient without
spending a fortune?

Jacobs and Gilhousen reached an ingenious realization.
During a wireless phone call, considerable network capacity is wasted by the
pauses that naturally occur. That capacity vanishes…taking profits with it.

So Jacobs and Gilhousen wondered if you could fill those
pauses with bits and pieces of other conversations. In effect, what they
proposed was the equivalent of rapid lane changes for a conversation — without
any loss of call quality.

If they could pull that off, wireless networks could
become three times more efficient…and Jacobs and Gilhousen could pocket millions
of dollars.

They went on to develop the technology that would digitize
a wireless voice conversation so that it could be taken apart and put back
together. The typical zeroes and ones of a digital format would be precisely
assigned to the pauses on neighboring channels and then meticulously reassembled
at both ends of the conversation. And the people talking
would never know it.

When their breakthrough evolved from satellite systems to
cell phone networks, Jacobs and Gilhousen hit pay dirt.

Today, about 70 million cellular subscribers rely on
QUALCOMM’s breakthrough. In return, shareholders have been rewarded quite
handsomely. Since its IPO in 1991, QUALCOMM’s market cap has hit $59.8 billion. 
Not too shabby.

While it’s obviously too late for any small-cap investor
to get in on the ground floor of QUALCOMM, there’s another California company
458.1 miles due north — right in the heart of Silicon Valley — that’s toiling
away on the next big thing in cell phones.

The company is called Ditech Communications Corp., and its
innovation could make this small-cap whiz the next QUALCOMM based on this
equation: What QUALCOMM originally did for wireless-network efficiency, Ditech
does today for cellular call quality.

In a nutshell, Ditech develops systems that eliminate
annoying echoes in cell phone conversations. While Ditech’s team in Mountain
View is home to a bunch of brilliant propellerheads who design the hardware and
software, the chief financial officers of the biggest cell phone providers are
extremely interested in its products.

That’s because when it comes to the viciously competitive
cell phone market, service providers such as Sprint, Nextel, Verizon, Cingular
and AT&T understand the equation between high call quality and low customer
churn.

In fact, it’s because the carriers have been buying
products from so many different companies that they have the call-echo problem
to begin with.

The problem is that computers used in cellular networks
adhere to international standards that allow them to work together. These
computer standards are extremely hairy cousins to the universal engineering
specifications that let you plug in a toaster, change a light bulb and move your
telephone.

Despite the best intentions of the computer makers and the
engineers who designed the standards, achieving compatibility between the
systems is an extreme sport — not for the faint of heart. The computers that
route your call, let you roam and keep track of your minutes come from different
manufacturers, each with varying degrees of loyalty to the standards. So what
you have on your hands is a classic summer family reunion: Everyone is related,
but they really can’t stand each other. A side effect of this insanity is the
cell phone echo that sounds like you have water in your ears.

Ditech’s products are akin to a computer-systems mediator.
Ditech’s systems plug directly into the network and help eliminate the
interference and static that arises from incompatibility issues. The result?
Goodbye, echo.

Silicon Valley insiders would call this breakthrough a
“disruptive technology.” It means that the obvious and foreseeable path of
development is suddenly disrupted by a surprise innovation.

QUALCOMM did it by dramatically improving the number of
calls that could be squeezed onto a cell phone channel, helping drive down the
economics so that anyone could afford to make a call.

The power of Ditech’s echo-cancellation software won the
attention of semiconductor giant Texas Instruments — and gave Ditech
significant heft. In April 2002, Ditech sold its echo-cancellation software unit
to Texas Instruments for $26.8 million. The deal was a stroke of
genius.

First, Ditech got a boatload of money that it could plow
back into the business. Second, Texas Instruments is licensing the software back
to Ditech — entitling Ditech to all of the upgrades by the chip maker. This
makes a lot of sense if you compare the R&D budgets of Texas Instruments
(whose revenues are $12.5 billion) and Ditech (with 2004 revenues of $69.6
million). Third, Ditech can continue selling the software independently or
through joint marketing and sales arrangements with Texas Instruments — the
biggest chip supplier to the cell phone industry.

Regardless of how Ditech gets through the door of cellular
service providers, the benefits of the echo-cancellation software to them are
abundantly clear.

Ditech’s echo-cancellation solutions encourage people to
use their cell phones more frequently. This is a very big deal, because it
drives up call minutes and improves customer satisfaction. For cell phone
carriers, the cost of signing up new customers is on a steep rise. Nextel is a
prime example…

During the first quarter of 2004 alone, Nextel spent 31%
of its operating revenue, or $971 million, on getting new customers — that’s a
23.5% increase over the same period the year before, when the company spent $786
million. Those expenses include sales, marketing and retail operations. As a
separate line item, Nextel also sells its phones at below cost. The subsidy is a
carrot to attract more customers — a practice that the company may increase.

It’s easy to see why Nextel, along with its competitors,
will do almost anything to keep its customers happy. And one of the best ways to
keep customers is to provide awesome service, which is a tricky proposition
considering the tidal wave of new cell phone users coming onto the networks that
drive constant upgrades.

Research firm International Data Corp. expects the number
of wireless subscribers worldwide to hit 1.5 billion by the end of 2004. You can
bet that each one of those 1.5 billion customers will drop their service
provider like a hot potato if their call quality stinks.

Based on its experience, Ditech has several new products
optimized for broadband. The company continues to enhance its solutions for
satellite communication as well — the same market that gave QUALCOMM its start.
And Ditech is concentrating heavily on Voice over Internet, or VoIP, as it’s
called.

VoIP is red hot. It’s nearly impossible to open a business
magazine without reading about VoIP. It was a front-burner issue for former FCC
Chairman Michael Powell, who wants to make the technology widely available to
drive down phone-call costs to that of e-mail. That’s CHEAP. Especially for
international calls.

But one of the biggest stumbling blocks to VoIP has been
call quality. Not only can the calls suffer from echoes, but also from a lag
between the callers — those surprise dead spots. The carriers, meanwhile, are
eager to adopt VoIP because it will save them billions of dollars in upgrading
and maintaining the archaic telephone network already in place.

Looking ahead to the rapid evolution of cellular and VoIP,
Ditech is ideally positioned to cash in. And given that the stock is hovering
near its 52-week low, this may be the time to strike.

Here’s why…

On March 23, Standard & Poors announced the addition
of Ditech to its S&P 600 SmallCap Index. In reviewing the criteria for index
additions, S&P looks for companies that have a “reasonable per-share price”
and “financial viability, usually measured as four consecutive quarters of
positive earnings.”

In Q3 2004, the company reported revenues of $21.3
million, which gradually climbed that year to peak in Q1 2005 at $25.5 million
in Q1 2005…only to dip back to $21.3 million in Q3 2005. Likewise, EPS during
the period started at 20 cents, getting as high as 29 cents in Q2 2005…only to
settle back down to 21 cents in Q3 2005.

But get this: During that year-over-year period, gross
margins soared from 66% to 78%.So why did the company’s stock tank from a
52-week high of $26.87 to $12.74 as of 10:35 this morning?

The answer is found in a press release from Nov. 3, 2004,
when Ditech reported preliminary Q2 2005 results. That’s when management broke
the bad news: The company could not fulfill a $5 million order to two new Asian
customers, impacting second- and third-quarter sales. Suddenly, Ditech fell off
a cliff…

On Nov. 3, Ditech closed at $22.29. On Nov. 4, it opened
at $15.00. Overnight, the company shed 32.7% of its value in an avalanche of
trading…and except for a spike the stock has been in a steady
decline.

Does that make Ditech a value play? It’s very possible.
The company continues to develop groundbreaking products for a world class
customer base. By diversifying into VoIP, Ditech is selling into a $6 billion
market, according to Infonetics Research. And in December last year, the company
embarked on $35 million stock buyback program —
telling Wall Street that it has a bright future. Or does it?

Because since Nov. 4, 2004, Tim Montgomery, Ditech’s
chairman, president and CEO, has dumped at least 300,000 shares in a series of
planned sales and exercised options.

Yet on March 20, 2005, Barron’s reported that Ditech
shares were poised to rally, citing a a recommendation from small-cap brokerage
B. Riley, based on projected revenues and its VoIP product line.

The next quarter could be the turning point for Ditech. If
management can convince Wall Street that it has its supply kinks worked out,
that sales and margins will continue to rise and that the buyback program
solidifies the stock, it’s possible that Ditech could regain its momentum and
become the next QUALCOMM.

Happy investing,

Irwin Greenstein

March 29, 2005

The Echo Killer was originally featured in the Penny Sleuth.