At The Motley Fool, we're looking for "the next Microsoft." That is, in our Motley Fool Hidden Gems service, we're trying to find a small-cap company that is good enough to grow by leaps and bounds over the years, giving outsized returns to Foolish investors.

One tool Andy Cross, co-advisor of Hidden Gems, and I have developed is this small-cap report card. (For a detailed description of how it works, read this guide.) With it, we get a sense of how good potential investments really are.

Today's subject: DryShips (Nasdaq: DRYS).

It starts with management
Here's how the management section stacks up:

Metric

Trailing 12 Months

Weighting

Score
(out of 5)

Tenure, average, CEO and CFO (years)

17

10%

5

Value of shares owned by CEO  

$57.5 million

10%

5

Salary of CEO

At least 1.35 million euros

10%

2

Cash flow from operations > net income (millions)

$366 vs. $50

10%

4

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

While CEO George Economou has been in the maritime industry for more than 30 years, the average is dragged down by Chief Financial Officer Ziad Nakhleh, who has been in the industry for only five years. Essentially, Economou controls DryShips. A company he owns, Cardiff Marine, manages and charters the ships, while another company he owns, Fabiana, is contracted to DryShips to provide the company's CEO and CFO. And while DryShips itself has lost money for each of the past two years, cash flow from operations has exceeded net income in four of the past five, which is a positive thing.

It continues with competitive advantage
Return on capital has been all over the place since DryShips went public, with a low of 3.6% last year and a high of 36% in 2004. In 2008, the company took on a large slug of debt as it added underwater oil drilling to its business model. Since the company came public, ROC actually increased only once on a year-over-year basis.

Metric

Trailing 12 Months

Weighting

Score (out of 5)

ROC increase or steady?

3.7%

25%

1

Source: Capital IQ.

Don't forget the numbers
Here's how DryShips shakes out:

Metric

Trailing 12 Months

Weighting

Score (out of 5)

Debt / equity

102.9%

10%

1

Operating margin

39.3%

10%

1

Revenue growth

(11.6%)

5%

2

Net income growth

N/M

5%

2

Free cash flow growth (millions, YOY)

$(263) vs. ($311)

5%

2

Source: Capital IQ; N/M = not meaningful.

Remember, except for the debt/equity ratio, the score is how many years out of the past five each item grew over the previous year. That D/E ratio means that nearly half of the company's total capital is because of debt. Over the past 12 months, the interest coverage ratio is just 3.4, which is not too healthy.

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

Metric

DryShips

Diana Shipping (NYSE: DSX)

Eagle Bulk Shipping (Nasdaq: EGLE)

Excel Maritime Carriers (NYSE: EXM)

CFFO > Net income

(ttm and score)

$366 vs. $50

4

$152 vs. $122*

5

$83.3 vs. $18.3

5

$166 vs. $290

4

ROC increase?

(ttm and score)

3.7%

1

5.9%

2

2.4%

3

1.1%

1

Operating margin

(ttm and score)

39.3%

1

49%

2

29.9%

3

12.3%

1

Free cash flow growth

(ttm, YOY and score)

($263) vs. ($311)

2

$110 vs. $152*

1

($288) vs. ($111)

3

$105 vs. $113

2

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

*For the years ended Dec. 31, 2009, and Dec. 31, 2008.

This is a brutal industry that earns little on capital, as shown above. Returns are not very high and it's hard to grow those returns. Operating margins are generally high, though, but again, consistent growth is difficult. Of the four, Eagle Bulk appears to be the best on a scorecard view, but the free cash flow going in the wrong direction is not good. Maybe it would be better to look at bigger shippers, instead.

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

Weighting

Category

Final Grade

 

Management

 

10%

Tenure / experience

5

10%

Value of company owned

5

10%

Salary of CEO

2

10%

CFFO > Net income

4

25%

Moat

1

 

Financials

 

10%

Debt / Equity

1

10%

Operating margin

1

5%

Revenue growth

2

5%

Net income growth

2

5%

Free cash flow growth

2

100%

Total Score (out of 5)

2.35

 

Final Grade

C

Not entirely surprising. Plus, given public comments made by Economou in the past and the number and extent of related-party transactions, I would steer clear of this one.

We'll check back after each quarter to see if the company 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.

Fool analyst Jim Mueller is a beneficial owner of shares of Microsoft, but has no position in any other company mentioned. He works with the Stock Advisor newsletter service. Microsoft is a Motley Fool Inside Value recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool's disclosure policy got straight As.