Editor's Note: This column was originally published as an alert to subscribers to Stocks Under $10 on Dec. 20. It subsequently rose 35% and was removed from the portfolio on Dec. 22.Cell phones are everywhere. Global mobile media company Enpocket reports that 61% of Americans have cell phones, and the Street is expecting global handset sales will reach about 650 million units in 2005. Even so, making money in the space has never been more difficult for the passive investor, but we believe we've found an interesting angle. Readers of Stocks Under $10 know that we made some pretty good money trading around Skyworks ( SWKS)), which makes the "guts" of cell phones, earlier this year. But pricing pressure, seasonality and inventory cycles have made gaming the stocks of wireless component makers like Skyworks, Nokia ( NOK) and Motorola ( MOT) more difficult of late. However, we believe we found an opportunity to capitalize on wireless trends when we discovered Canadian wireless software maker Zi ( ZICA). A reader wrote in asking about the prospects for its technology, and after doing some research, we believe this is a company that is still in the early stages of its growth cycle and is not as prone to the cyclical nature of the business. We are going to buy an 800-share position in this Stealth Stock for the model portfolio here around $4.60, as we believe Zi can trade as much as 50% higher in 2005. The company creates embedded software for cell-phone manufacturers that is designed to make using text messaging technology more convenient. The company has patented predictive technology that significantly cuts down on the time it takes to send a message, with its auto- fill function that fills in commonly used words. For example, a message of "I will call you later" takes 17 key strokes and a couple of mouse clicks on a PC. This same message sent via a cell phone requires 45 touches, give or take a couple of mistyped letters and some backspaces.
The technology is more complex than it sounds, but the company's business model is relatively easy to comprehend. Zi earns about 15 cents on every phone sold containing its software, and that pricing has been firm in recent quarters after declining slightly last year. In addition, the company receives licensing and engineering fees for customized products and designs from manufacturers like LG and Nokia. Zi believes it has 15% of the total predictive text market share right now and we expect that number to increase as its technology improves and more manufacturers sign on to use its technology. The company's primary competition comes from Tegic Communications, a wholly owned subsidiary of cable behemoth Time Warner ( TWX) that currently has a majority share of the text software market. The 15 cents on 15% of the 650 million phones is very quantifiable and not all that exciting. We are intrigued more by its growth prospects, which are supported by strong fundamentals. Zi reported record revenue of $3.7 million and profit of 2 cents a share in the third quarter. The one analyst who covers the stock, Barry Richards from Paradigm Capital, is calling for sales to double from 2004 levels to $28.8 million in 2006. We believe the company has the balance sheet to support this expansion, with no debt and $10 million of cash. On Dec. 14, Zi put some of its capital to work, acquiring the handwriting-recognition software technology of Decuma AB, a Swedish software maker, for $1 million. We believe management is looking to do more deals like this to increase its product offerings. Handwriting recognition, along with other software like its bilingual product that learns speaking tendencies in several different languages and increases its international possibilities, could generate more in the neighborhood of $1 a phone and help it take market share from Tegic. It also could help it yield $1 a share or more in earnings in the next couple of years.
It's worth noting that hedge fund giant Lancer Capital owns about 50% of the company, and any selling by it could significantly pressure the stock. There has been no recent selling and there is no indication of future selling at this point, but given the inordinate effect this could have, it bears noting. Even so, Zi scores well in our Alpha factor, which gauges a stock's ability to make large moves on news -- and we believe the risk/reward is favorable at current prices. With only 33 million shares in the float and one analyst following the stock, Zi is a classic Stealth stock that is flying under the radar of most investors right now. As it increases its sales and grabs a bigger share of the market from Tegic, we believe more analysts will pick up coverage and institutions will drive this stock over the $6 level. P.S. Remember, stocks priced under $10 have the potential to move quickly. So, you might want to get our current recommendations now with a free trial to TheStreet.com Stocks Under $10.