"If you can't take a little bloody nose, maybe you ought to go home and crawl under your bed. It's not safe out here. It's wondrous. With treasures to satiate desires both subtle and gross. But it's not for the timid."
-- Q, Star Trek: The Next Generation

Sometimes, you take wisdom wherever you can find it. Because we seek market-beating riches in Motley Fool Hidden Gems, buying quality small caps after a good thumping can be a profitable path. Today's candidate: CryptoLogic (NASDAQ:CRYP).

Feel the short-term pain
CryptoLogic investors have had an entertaining August -- and we're barely a third in. Entering the month, the stock was already 24% off its 52-week high, and investors were greeted with Goldilocks quarterly numbers -- not too hot, not too cold -- that caused a further 15% downward drift.

And then investors took that bloody nose.

Betfair, one of CryptoLogic's 10 poker clients, advised management of its intent to bring its poker operations in-house. Discussions between the parties continue, but if Betfair walks, its departure would occur in early 2006 -- less than two years after going live with CryptoLogic software.

But you just got here!
Betfair's in-house move is an attempt to capture the full value of online poker's explosive growth. And the benefits are tempting -- CryptoLogic's poker haul has grown 180% over the prior year (my estimates). This despite the fact that more than 65% of CryptoLogic's clientele is international and the vast majority of current poker growth has been fueled by U.S. players. Betfair must agree with the industry watchers who say that the next high-growth market for poker is Europe -- Betfair's backyard.

Although moving operations in-house might seem like a good strategy, Betfair faces significant execution hurdles. First and foremost, it has no more than six months to produce and go live with a real-time, secure, multi-table, multi-currency poker application. Even if the company is already heavily in development, a real-time poker application presents myriad challenges.

Moreover, a term thrown around regarding poker sites is the need for "critical mass." This need is what has kept Internet retailers such as eBay (NASDAQ:EBAY) and Amazon.com (NASDAQ:AMZN) ahead of upstarts such as Overstock.com (NASDAQ:OSTK), Drugstore.com (NASDAQ:DSCM), Ubid.com, and even Yahoo! (NASDAQ:YHOO) Auctions -- a bigger forum provides a better experience for consumers. In the case of poker, CryptoLogic funnels multiple licensees into a common poker room to make certain there are as many full tables and betting limits as possible.

Up against PartyPoker or Paradise Poker, one of the criticisms of CryptoLogic is that it's not a critical mass leader. The loss of Betfair therefore affects CryptoLogic and its current loading of 6,700 simultaneous players. However, Betfair also sacrifices the participation provided by CryptoLogic's other licensees -- a far more pronounced effect. Going forward, the industry expects consolidation, so Betfair's inclination to shrink is puzzling.

Reading the numbers
News of Betfair's prospective departure sent shares of CryptoLogic down by as much as 27% yesterday. The stock recovered a bit and finished the day down by 17%. So is this a buying opportunity, or is that kind of bludgeoning warranted? At Hidden Gems, we ask that question each and every time one of our small caps experiences some volatility -- we want to know when to double down and maximize gains.

Let's first look at how much poker contributes to CryptoLogic's top line. Although the firm does not break out revenue by product line, we can approximate the amount by scrutinizing past press releases. The table below is based on my contribution estimates, and though the numbers aren't official, I believe it's a reasonable hypothesis:

2002 2003 2004 Q1 2005 Q2 2005 TTM
Poker Revenue $0.3 $4.4 $13.0 $5.5 $6.4 $20.4
Casino/Bingo/Other Revenue $34.1 $39.8 $50.7 $14.8 $13.5 $53.5
Total Revenue $34.4 $44.2 $63.7 $20.3 $19.9 $73.8
Poker as Percentage of Total Revenue 1.0% 10.0% 20.4% 27.0% 32.2% 27.6%
All estimates in millions of U.S. dollars.

Although the poker part of operations has experienced incredible growth recently, poker remains less than 30% of total revenue on a trailing-12-months basis.

Unfortunately, we know less about the individual contribution of poker licensees than we do about the company-wide revenue breakdown. Still, there are clues that afford us a reasonable guess. Management has said that seven licensees account for 95% of total revenue. If we assume that this number translates to the poker realm and that Betfair is one of the seven, it's a small leap to then conclude that Betfair contributes 3% to 5.5% of total revenue.

If Betfair is that insignificant, then why did the market give CryptoLogic such a haircut yesterday? When fellow Hidden Gems pick CantelMedical (NYSE:CMN) announced the loss of a distribution partner that represented 31% of revenue, it rightly shed approximately 40% of its market value. But given the circumstances above, CryptoLogic's punishment seems overblown.

Believe you me
To prove it, let's adjust our valuation -- although I'll be the first to admit that valuation can be more art than science (using the right inputs, you can justify almost any stock price). Yet even a dirty window can provide some illumination, so I'll proceed.

The company currently sells for less than three times its cash on hand. It is debt-free, has been cash-flow positive since going public, and carries a 1% dividend yield. The current EV/EBITDA ratio (the relative valuation metric of choice in the original recommendation) is 9.2, and my forward EV/EBITDA estimate after stripping out the loss of Betfair is 7.4. Using a conservative discounted cash flow model and projecting annual casino growth at just 5% (disappointing, but in line with the two most recent quarters), and decelerating poker growth over the explicit forecast period from today's lofty rate to in-line with casino, I'm still hard-pressed to justify a value today much below $30. The stock currently trades below $20 per stub.

The last word
I think Mr. Market has entered one of his depressive phases. Remember that Adobe Systems dropped more than 50% six times on its 19-year journey from small cap to market leader -- rewarding confident investors with market-crushing 25% compounded annual returns. CryptoLogic is there now. It's a solid small-cap cash machine selling at a reasonable price. Timid investors might be afraid of catching a falling knife, but that's why Hidden Gems is here to help subscribers know when the market's right and when the market's wrong. To join our team, consider a 30-day free trial to Motley Fool Hidden Gems. Since inception, lead analyst and Fool co-founder Tom Gardner has helped subscribers beat the market by more than 20 percentage points on the back of sound analysis and a contrarian spirit. Click here to learn more.

Jim Gillies owns shares of CryptoLogic and has contributed to its strong historical earnings through his inept blackjack play. He owns shares of no other company mentioned. Overstock.com is a Motley Fool Rule Breakers recommendation. Amazon.com and eBay are Motley Fool Stock Advisor recommendations. The Motley Fool has a disclosure policy.