Small-Cap Report Card: Buffalo Wild Wings

We've all heard that "good things come in small packages." But the investing version of that maxim might be, "Great returns come from small companies."

Small-cap companies, those between roughly $250 million and $2 billion in size, can offer some of the best returns around as they become the large caps of tomorrow. It's pretty tough for a company worth $200 billion or more, like ExxonMobil or Apple, to increase in size by 500%. But for a well-run small cap, that big a gain is potentially just the beginning.

Did you notice the phrase I slipped in there -- "Well-run?" The key to finding small-cap companies that can give outsized gains lies in those words. That's where this small-cap report card can help you.

Today's subject: Buffalo Wild Wings (Nasdaq: BWLD)

It starts with management
In any company -- but especially small ones, because of the higher influence that management wields -- we want management aligned with all stakeholders, particularly shareholders. First, the top brass should have extensive industry experience, either running the company for several years, or working at similar companies. Skills in one industry aren't necessarily transferrable to another. Fortunately for B-Wild, CEO Sally Smith and CFO Mary Twinem have been with the company for at least 15 years each.

Second, management's own interests should be aligned with those of shareholders, by having a significant portion of executives' personal wealth tied up in the company. Founders often do, but newcomers can arrive with far less of a stake. In any event, I'd like to see at least $10 million in ownership. With B-Wild, Smith and Twinem are not the founders; unfortunately, the two of them average less than $5 million worth of company stock. That's less than 1% of the company each. Not so good.

Third, because small caps rarely have a huge revenue base, I don't want to see a lot of that revenue going into the pockets of management, rather than making it to the bottom line. An annual salary of $1 million is a pretty reasonable level, and Smith's pay easily comes in under that.

Finally, I'd much rather see that management is aggressive about growing the business, not about massaging the accounting. Aggressive accounting is often a sign that management is more worried about the "numbers," and less worried about the business behind those numbers. Stuffing inventory channels in order to recognize revenue sooner when sales are slow is one example.

One of the early signs of aggressive accounting is when cash flow from operations -- the cash actually moving into the business -- lags net income. That can happen on occasion, but for the vast majority of the time, CFFO should exceed net income. No worries here, as CFFO has exceeded net income for each of the past five years for Buffalo Wild.

Here's how the management section stacks up:

Source: Capital IQ, a division of Standard & Poor's.

It continues with competitive advantage
Of course, having the best management in the world doesn't help the investor if the company doesn't have a competitive advantage that will contribute to growth. This is the "moat" that Buffett is so fond of talking about. Here, I'm going to use the return on capital (ROC) and look at the trend over the past several years. If the moat is eroding, competitors are coming in, and the returns will start declining. Buffalo Wild has increased its ROC for four of the last five years, which is pretty good.

Source: Capital IQ.

Don't forget the numbers
Here, I'm obviously looking for both revenue and net income growth over the years, but also free cash flow growth -- that's the money on which investors actually have a claim. I also prefer to invest in companies with low levels of debt, since they can better survive bad times. Finally, I like to see operating margin growing, since this ties into how well the company contains both the cost of goods and the cost of running the business. Except for debt, I'm looking at multiyear trends. For the scores below, I'll give them one point for each year out of the last five when they grew the metric year over year. And of course, low debt scores higher.

Here's how Buffalo Wild shakes out:

Source: Capital IQ.

Bonus section
An "ungraded" section lets us see how our company stacks up against some competitors in several of the metrics above:

Source: Capital IQ; TTM = trailing 12 months; dollar amounts in millions.

Krispy Kreme actually scores better than B-Wild in two of the four metrics, and the same in the other two, though it does have a lower ROC and operating margin. Wendy's and Sonic, besides having lower ROCs, also score lower than B-Wild. So among these four, giving weight to its higher ROC, B-Wild seems to be the better potential investment.

Add it all up
With everything in, here's how Buffalo Wild scored:

Not entirely surprising. We're not too happy about Sally Smith's low ownership, and the company's been finding it difficult to grow revenue during the recession. Still, a B+ is a solid grade. We'll check back after each quarter to see whether B-Wild can bump it up a notch.

If you'd like to see how other small cap companies stack up, you can always take a free, 30-day trial to our small-cap newsletter/real-money portfolio service, Motley Fool Hidden Gems.