Will AutoZone Run Out of Gas?

In a previous article about small-cap stocks turned large cap , I discussed ARM Holdings (NASDAQ: ARMH ) and the pitfalls this tech stock faces now that it has grown substantially in recent years. The pitfalls of ARMH are not unique — small caps as measured by the Russell 2000 index have significantly outperformed the broader market. Specifically, small-cap equities that make up the Russell 2000 index have gained about 20% in the last year — about twice the S&P 500, which focuses on large-cap stocks. The appeal of smaller companies is obvious. My favorite example of blue-chip bloat is McDonald's (NYSE: MCD ) — a good stock that has outperformed the market recently but a company so ubiquitous that one MCD report says the farthest distance you can be from a McDonald's in the U.S. is 115 miles, or a less than 2-hour drive! MCD has grown thanks to innovative product developments and marketing. But small-cap companies do need to worry about new products — they can simply grow by doing what they do well already on a larger scale. What's more, these picks are more nimble and able to tackle the market trends of the day. But every small cap runs into a wall eventually, when it becomes too big to be considered a minor player any more. That means the explosive growth potential is probably over, and that the company will start behaving more like a lazy blue chip. To help you figure out the tipping point for the surging small-caps in your portfolio, here is a look at auto-parts store AutoZone (NYSE: AZO ) and why its recent growth may be slowing down. AutoZone (AZO) Market cap at the end of fiscal 2007: $8.2 billion Current market cap: $10.8 billion AutoZone (NYSE: AZO ) has been on a tear in the last two years. Unlike the rest of the market, AZO shares weathered the March 2009 low remarkably well — actually gaining  15% from the first of the year through March 10, 2009 while the broader market shed 21%. And the run hasn't really slowed down lately, with AutoZone tacking on 50% since Jan. 1, 2010, compared with about a 7% gain for the S&P 500 index. So what's behind AutoZone's success? Store expansion is a big part of the equation — from 3,300 stores in 2003 to 4,000 stores in 2007 to almost 5,000 stores worldwide at present day. Also, the relatively recent addition of a commercial sales program that provides delivery of parts and other products to repair shops ensures AZO serves businesses as well as consumers. On top of that, consumer are putting off new-car purchases and driving and maintaining older cars.  All those contribute to the success for this auto parts retailer. However, AutoZone hasn't been the only parts store surging. Competitor O’Reilly Automotive, Inc. (NASDAQ: ORLY ) has a market cap of over $8 billion, 3,500 stores in its network and annual sales projected to top $5.3 billion this fiscal year – up almost 10% from the previous year. The 2008 acquisition of CSK Auto has made this stock a firm competitor in the auto-parts retail space. And then there's Advanced Auto Parts (NYSE: AAP ) with a similar tale — $5.8 billion in projected revenue this fiscal year, 3,400 stores and 8% sales growth projected for the year. AutoZone's projected sales growth for the year, however, is just north of 5%. So it appears that while macroeconomic trends are favorable to the auto-parts business, the competition is heating up and smaller competitors holding their own or even narrowing the gap between themselves and AZO. Once that trend dissipates, will AutoZone be able to continue its growth or is the auto parts marketplace nearing a saturation point? AZO could opt to turn to an acquisition to continue its momentum. The most realistic option may be online retailer U.S. Auto Parts Network (NASDAQ: PARTS ) to capitalize on Internet sales, but such a move would be costly and could backfire if new car sales rebound and parts sales roll back. The bottom line is that though AutoZone has been seeing great growth in recent years thanks to consumer trends, it could be approaching a tipping point in the market. Unless one of its major competitors cedes ground or unless it can come up with a new revenue stream, AZO is going to run out of gas. You can't rely on favorable economic trends to last forever, and with a market cap of nearly $11 billion, AZO is getting a bit too big for small-scale acquisitions to have much of an impact on the bottom line. Jeff Reeves is editor of InvestorPlace.com. As of this writing, he did not own a position in any of the stocks named here. Follow him on Twitter at http://twitter.com/JeffReevesIP .
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