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By Jeremy Glaser and David Whiston, CFA, CPA, CFE | 10-03-2014 12:00 PM

Buffett Likes Auto Dealerships. Should You?

Cost advantages, intangible assets, and profitable parts-and-services operations may have attracted Buffett to auto dealers, but current share prices on the public firms don't look attractive today.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Warren Buffett's Berkshire Hathaway jumped into the auto dealer space this week by announcing that it was acquiring the Van Tuyl Group. I'm joined today by David Whiston, our senior equity analyst who covers the dealerships and also many of the other U.S. auto companies. We're going to take a look at what this could mean for the industry.

David, thanks for joining me.

David Whiston: Thanks, Jeremy.

Glaser: Let's start with some of the dynamics of the auto dealers. Why would this be an industry that Warren Buffett would even look at? Does it have that economic moat he's often looking for?

Whiston: It's a great question, because it's a sector that's really been off even our institutional clients' radar, because most of these firms have pretty low market caps, although they have grown considerably in the last few years.

All of the dealers we cover at Morningstar have a narrow economic moat, and the sources for them are primarily a cost advantage and an intangible advantage. Lithia Motors in Oregon has a very unique third moat source of efficient scale, a very nice barrier to entry, because they are the Walmart of auto dealers. They focus on rural markets like Midland, Texas, or even Fairbanks, Alaska, where they are the only brand within 100 miles for a franchise.

But primarily the dealerships have a cost and intangible advantage. On the cost side are going to be the AutoNations of the world. They are the largest U.S. dealer, for example. They just have a lot more economies of scale than most of these dealer groups, which are primarily family-owned businesses. That scale is anything from purchasing tools for your mechanics to uniforms for the crew to IT supplies. You can just get better rates on it than the local family Ford dealer in your town. It also helps for making acquisitions to grow; this is very much a roll-up acquisition industry that's been consolidating for nearly 70 years now.

On the intangible side, it's really two things that are interesting. One is, the large dealer groups can be much more efficient with their working capital in terms of allocating their inventory around a metro area. Basically, your Ford store gets a Toyota trade-in, and if you're AutoNation, you've got a Toyota store on the north side of town where you think it will sell better. So you can move that car; whereas, the local Ford dealer is going to be stuck with that Toyota. Hopefully they will still sell it, but they won't necessarily get as many Toyota customers coming onto the lot.

The other crown jewel of the dealer space is the parts and service business. This is only about 15% of the public dealers' annual revenue. But it's actually close to 45% to 50% of their total gross profit. So it's immensely profitable, and it's a very nice, steady, almost annuity-type business that you can get both in good times and bad.

In a recession, these dealers see a favorable gross margin shift, where gross margins go up, because more business comes to parts and service due to lower new-vehicle sales. But you get some deleveraging on the SG&A side, meaning they can't cover their overhead as well. So overall, operating margins still go down. So, I wouldn't say it's a recession-proof business, but it's a very nice business to have throughout an economic cycle.

Glaser: If these businesses have these attractive attributes, do you see any competitive threats that can really squeeze it--maybe direct to consumer sales? Is there anything on the horizon that could be a challenge?

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