Technology can be a difficult sector to understand, given the rapid obsolescence of most products and the potential for disruptive innovations. In my mind, one key to investing in the sector is to find a company with an easy-to-understand technology that has a niche in the market. Motley Fool Hidden Gems Watch List company Rimage (NASDAQ:RIMG) fits the bill.

After a very strong second quarter, in which earnings were up 48% on the back of a 14% growth in revenue, the stock jumped 20% this morning. Let's dig a little deeper into the business.

Easy to understand
Rimage is a leading provider of disk-publishing services. It provides disk-duplication products that can mass-produce recordable CDs or DVDs. The best part about Rimage's products and services is that its market isn't limited to large businesses -- its technology comes at price points low enough to be viable for small businesses as well. Rimage has a sustainable competitive advantage in its markets for three main reasons.

First, its product and customer bases are diversified. Rimage seeks to exploit all markets where customized storage may be necessary. For example:

  • Check imaging. Increasingly, banks are eliminating paper and microfilm systems for CDs/DVDs. This process began earlier in the decade among the biggest banks, but as costs have come down, the trend has spread to smaller banks. Rimage technology offers banks cost-efficient ways to store information, from $10,000 for lower-capacity models to $30,000 for higher-end models.

  • Emerging retail markets. Digital photography, music-on-demand, and video-on-demand are becoming more popular here. Interactive kiosks are becoming more prevalent in stores like Walgreen's (NYSE:WAG). The kiosks customize information and put it on disks, essentially placing Rimage's entire business in front of consumers every day.

  • Medical applications and imaging market. According to one of the company's online presentations, MRIs and other medical scans will be more cost-effective using CDs/DVDs than film. This alone is causing medical facilities to switch to CDs/DVDs.

Rimage is capitalizing on its technology by getting it into as many markets as possible. To support these efforts, in the last fiscal year Rimage reinvested 6% of revenues into R&D. The company expects to increase that to 7% to 8% this year (and it did this quarter).

Market, sell, repeat
In addition, more than 40% of Rimage's revenues come from repeat purchases, including ribbons and cartridges, CDs, and DVDs. This is a rather large percentage for a hardware technology company, and it's something investing legend Peter Lynch has mentioned as a key attribute of a superior investment.

New technologies
Finally, Rimage has positioned itself to profit from the up-and-coming Blu-ray disks that will soon be flooding the market. The company recently announced that it will be using as many as four Pioneer BDR-101A disc/DVD writers in its highest-performing Blu-ray disc publishing solution. Each Pioneer disc offers 25GB of storage, which equates to about 6,200 of your favorite songs! These new products should add to Rimage's bottom line. (For more about Blu-ray, click here.)

What about the numbers?
Revenues in 2005 were up 35%, ending the year at $95 million. Rimage sports a market cap of $220 million, while its balance sheet shows $53 million in cash and no debt, putting enterprise value at $167 million. On the downside, gross margins have been slowly decreasing over the past two years. They dropped from 49% in 2003 to 46% this past year, raising questions about the company's control over its costs. Management has commented about high gross margins, citing Rimage's increased material purchases in areas that have high growth potential.

Net margins are down as well. In 2003, net margins were 14%; in fiscal 2005, they were 12%. (They seem to be directly related to the higher costs of materials.) However, it should also be noted that Rimage's recurring revenue streams tend to carry lower gross margins. So while this shift in revenues tends to be good for the top line, we need to keep a close eye on gross margins as well.

The Foolish bottom line
Decreasing margins aren't the company's only risk. Rimage will eventually be competing against companies offering online storage. Management believes its products are more cost-effective and efficient than that solution at present. But with stalwart technology companies -- think Google (NASDAQ:GOOG) and Yahoo! (NASDAQ:YHOO) -- starting to provide data storage via the Internet, this remains an open question.

This industry has plenty of barriers to entry, but there will always be some sort of competition; how will Rimage respond? Management has exciting ideas on paper and a good grasp on where its technology can take the company from here. Couple that with a solid balance sheet, and it's clear that Rimage has a lot going for it. However, decreasing margins and the competition of online storage are factors I'll be watching.

Rimage is a three-time Hidden Gems Watch List selection. For full access to Hidden Gems, the Fool's small-cap newsletter service that is beating the market by an average of 18 percentage points, click here to start a 30-day free trial. There is no obligation to subscribe.

This column was adapted from the June 29 Hidden Gems Daily column.

Foolish intern Mike Kasprzyk does not own shares of any company mentioned in this article. The Fool has an easy-to-understand disclosure policy.