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: Western Refining (NYSE: WNR).

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

Metric

Trailing 12 months

Weighting

Score (out of 5)

Tenure, avg. CEO & Exec. chair (years)

13.5

10%

5

Value of company owned, avg. CEO & Exec. chair

$32.32 million

10%

5

Salary of CEO

$503,000

10%

5

CFFO > Net income (millions)

($126) vs. ($119)

10%

4

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

Both Paul Foster (former CEO and now executive chairman) and Jeff Stevens (CEO) have more than 6% ownership stakes in the company, averaging about $32 million, so their interests are well-aligned with shareholders. Cash flow from operations (CFFO), though looking bad at -$126 million over the past year, has actually been handily positive for the past five fiscal years, and exceeded net income in four of those years. However, the company must recover from the current situation, as you'll see below.

It continues with competitive advantage
Return on capital was really good a few years ago, topping 55% in 2005. Since then, it's fallen off a cliff. Not an extremely strong moat, unfortunately.

Metric

Trailing 12 months

Weighting

Score (out of 5)

ROC increase or steady?

0.3%

25%

1

Source: Capital IQ.

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

Metric

Trailing 12 months

Weighting

Score (out of 5)

Debt / Equity

162%

10%

0

Operating margin

0.1%

10%

2

Revenue growth

1.8%

5%

4

Net income growth

N/M

5%

3

Free cash flow growth (millions, YOY)

($209) vs. ($195)

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. That D/E ratio results from the more than $1.7 billion in debt Western Refining took on back in 2007 to make an acquisition. Currently, debt sits around $1.25 billion; the company's been paying down its obligations, but the negative CFFO noted above is not a good sign for its ability to continue doing so.

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

Metric

Western Refining

Valero Energy (NYSE: VLO)

Sunoco (NYSE: SUN)

Tesoro (NYSE: TSO)

CFFO > Net income(ttm & score)

($126) vs. ($119)

4

$2,186 vs. ($1,567)

5

$1,595 vs. ($204)

5

$306 vs. ($234)

5

ROC increase?

(ttm & score)

0.3%

1

1.3%

1

3.3%

2

(1.3%)

2

Operating margin

(ttm & score)

0.1%

2

0.6%

2

0.9%

1

(0.6%)

2

Free cash flow growth

(ttm, YOY & score)

($209) vs. ($195)

2

$425 vs. ($366)

1

$812 vs. ($590)

3

($68) vs. $238

2

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

Refining is a tough business, and each of the companies above has lost money over the past four quarters. Returns on capital have also been poor. Operating margins sit at razor-thin levels, having dropped from the mid-to-upper-single digit levels of just a few years ago. All four of these companies show the difficulty this industry faces.

Add it all up
With everything in, here's how Western Refining 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

4

25%

Moat

1

 

Financials

 

10%

Debt / Equity

0

10%

Operating margin

2

5%

Revenue growth

4

5%

Net income growth

3

5%

Free cash flow growth

2

100%

Total Score (out of 5)

2.80

 

Final Grade

C

In this case, "C" does not mean "average." There's no dark secret to finding good small caps to invest in, and in this case, I'd stay away for a bit. Western Refining has well-motivated management, but it's in a very tough business. When people cut back on travel and gas and oil prices drop, good times can disappear in a hurry. Unfortunately, with its 0.1% operating margin and the relatively high debt level, Western Refining's interest coverage ratio is a measly 0.1. Not good. Unless management can improve those numbers, this company could get into serious trouble pretty quickly.

We'll check back next quarter to see whether Western Refining 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 As.