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.

Andy Cross, co-advisor of Hidden Gems, and I have developed a tool we call the "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: STEC (Nasdaq: STEC)

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

Metric

Trailing 12 Months

Weighting

Score (out of 5)

Tenure, avg. CEO & CFO (years)

12.5

10%

5

Value of company owned, avg. CEO & CFO

$28.1 million

10%

5

Salary of CEO

$515,000

10%

5

CFFO > Net income (millions)

$46.4 vs. $47.7

10%

2

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

It sure helps when the company's founder still runs things. CEO Manouch Moshayedi has been in that spot for the past 20 years and he, alone, owns 8% of the company. But that last category is a bit worrisome. In the three years (of the last five) where CFFO (Cash flow from operations) was less than net income -- 2005, 2006, and 2008 -- there were relatively large inventory expenditures or accounts receivable increased or both. And in 2009, A/R increased by $35 million, some 80% and faster than the 56% growth in revenue, but the company earned enough in net income to keep CFFO high. Investors should keep an eye on this situation.

It continues with competitive advantage
Return on capital has swung wildly, from 1.6% to 25.2% over the past five full years. Not very consistent, indicating a not very strong moat. Thus the low score:

Metric

Trailing 12 months

Weighting

Score (out of 5)

ROC increase or steady?

14.6%

25%

1

Source: Capital IQ.

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

Metric

Trailing 12 Months

Weighting

Score (out of 5)

Debt / Equity

0%

10%

5

Operating margin

19.1%

10%

2

Revenue growth

12.6%

5%

3

Net income growth

104.1%

5%

3

Free cash flow growth (millions, YOY)

$39.3 vs. $28.2

5%

2

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

Remember, except for the D/E ratio, the score is how many years out of the last five each item grew over the previous year. The debt situation is excellent -- none -- but the company has a hard time growing revenue or net income consistently. And that's reflected in the number of times free cash flow has actually grown year-over-year.

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

Metrics

STEC

SanDisk
(Nasdaq: SNDK)

Micron Technology
(NYSE: MU)

Western Digital
(NYSE: WDC)

CFFO > Net income

(ttm & score)

$46.4 vs. $47.7

2

$1,340 vs. $1,063

5

$2,376 vs. $1,455

5

$1,942 vs. $1,382

5

ROC increase?

(ttm & score)

14.6%

1

16.5%

1

6.8%

2

21.7%

1

Operating margin

(ttm & score)

19.1%

2

29%

1

16.3%

2

15.5%

4

Free cash flow growth

(ttm, YOY & score)

$39.3 vs. $28.2

2

$1,275 vs. ($48)

3

$2,058 vs. ($67)

3

$1,205 vs. $786

4

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

Of the four, Western Digital scores the highest in the categories shown. But even it has difficulty keeping ROC from eroding. The last time it actually grew ROC or held it steady was in 2005, when it was at 24%. It has since degraded to 12%, though the TTM level is promising. SanDisk and Micron Tech are worse, with ROC going negative in the last two to three years, meaning they lost money.

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

Weighting

Category

Final Grade

 

Management

 

10%

Tenure / experience

5

10%

Value of company owned

5

10%

Salary of CEO

5

10%

CFFO > Net income

2

25%

Moat

1

 

Financials

 

10%

Debt / Equity

5

10%

Operating margin

2

5%

Revenue growth

3

5%

Net income growth

3

5%

Free cash flow growth

2

100%

Total Score (out of 5)

3.05

 

Final Grade

B-

About what I expected, given the above. Aside from strong scores on management and its strong balance sheet, STEC doesn't score very high. I would call it a borderline investment.

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

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Fool analyst Jim Mueller is a beneficial owner of Microsoft, but does not have a position in any other company mentioned. He works with the Stock Advisor newsletter. The Motley Fool's disclosure policy got straight A's.