Part of our process of finding undiscovered stocks involves monitoring consumer trends to find little-known companies poised to benefit from those trends -- and right now there is enormous consumer demand for handheld gadgets, from MP3 players to next-generation cell phones. We researched these devices to identify companies that supply the manufacturers, and our top pick is International DisplayWorks ( IDWK), which manufactures small liquid crystal display (LCD) screens for these devices. International DisplayWorks was recently trading at $5.55, and we're adding the stock to our watch list. We will consider taking a position in IDW once we free up money in the model portfolio for a speculative position and get some clarity from the company's management team about its turnaround efforts. That said, risk-tolerant investors should consider taking a small position in IDW now with the caveat that the position may take several quarters before potentially producing a double-digit percentage return. We like the momentum of the LCD business. Although LCD panel prices have been declining -- technology Web sites are speculating that Wal-Mart will offer a 32-inch LCD television that is priced below $1,000 for the holidays -- International DisplayWorks' niche is small screens for consumer electronics devices. This segment is experiencing enormous volume growth for everything from MP3 players and cell phones to portable navigation and medical devices. We expect this volume growth to more than make up for falling prices in the coming few quarters and allow International DisplayWorks to trade higher as a result. The company's shares are depressed right now -- off some 37% in 2005 -- due in part to a recent disappointing earnings report and forward sales guidance that was much weaker than the Street was expecting. For the fiscal third quarter ended in July, International DisplayWorks reported sales of $23.6 million and earnings of 3 cents a share. Although this was a 103% top-line increase from the 2004 period and marked the company's ninth quarter of sequential revenue increases, the Street was looking for sales to come in closer to $25 million. Making matters worse, International DisplayWorks said its fiscal fourth-quarter sales should come in between $22.5 million and $25 million, quite a drop from its previous revenue guidance of $40 million for the quarter.
The prime culprit was struggling MP3 player maker Creative Technology ( CREAF), which accounted for 20% of IDW's sales in the quarter. While Creative's problems -- namely competition, an inventory glut, and pricing pressure from other MP3 makers -- are likely not behind the company just yet, we believe its travails are more than priced in International DisplayWork's stock at just 10.5 times 2006 estimated earnings of 48 cents a share. Given our favorable risk/reward expectations, we believe investors will react more positively to future earnings reports that may show signs of stabilization at Creative. While not entirely in the clear just yet, Creative, which makes MP3 players and speakers, wrote down $20 million in inventory last quarter. Also, another of IDW's 10%-plus customers, electronic manufacturer Jabil Circuits ( JBL), has delivered solid earnings results lately, which could soften the impact of any future weakness at Creative. Like many small tech companies, IDW needs to improve its financials. The company ended the third quarter with $6 million in cash, $7 million of available cash under an existing credit line, and just $2.6 million in current portion of long-term debt. And with sales and earnings forecast by analysts to grow some 93% and 320% to $180 million and 45 cents a share, respectively, in 2006, we are comfortable that the company's liquidity won't be an issue. IDW is also entering the color LCD market, which should greatly expand its customer base and enable it to increase total production. That said, IDW is a speculative long-term investment with risks. A slowdown in the economy that cuts into discretionary income for consumers, for one, could derail sales of electronics and therefore hurt the entire supply chain. Also, continued weakness at Creative could hurt IDW's earnings in 2006, although the damage should not be as severe as last quarter. But the stock's weak performance in 2005 makes us more comfortable with the risk/reward ratio from the current quote. And with just five analysts covering the stock and some 10% of the float already sold short, we believe downside on further bad news will be limited by the negative sentiment surrounding the stock. As part of our Stocks Under $10 service, we name stocks to our watch list and then track them as closely as those that are added to the model portfolio. We will continue to update you on IDW.