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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Whiston: Broadly speaking for the industry, there are a few trends going on. Especially for some of the smaller dealers, which don't necessarily have deep pockets, there are these constant "store imaging" requirements, where the automaker or the OEM or the factory (in dealer parlance) will say, you've got to spend certain millions of dollars to make your store look this way and this way alone. That can be anything from marble tiles to more Internet connections, to all sorts of expensive renovations.
Especially some of the smaller businesses, they either can't get a loan from the bank or they are just tired of it, or they are getting close to retirement, and they say, I don't want to take out a $5 million loan now when I think I might sell the business in the next five years anyway. So I'm just going to go ahead and give AutoNation a call. And now, of course, you'll have a different buyer in there to sell to in Berkshire Hathaway.
The other big threat is the CFPB, the Consumer Finance Protection Board, which has been very much after the dealer space for about a year now. The public dealers get a dealer reserve, which is the markup they put to consumers, and then they also get a commission on the financing. They are not actually a lender themselves, but it's a 100% gross profit business--very profitable. But the public dealers, at least that I cover, they mostly earn a flat-fee basis. So they are probably immune from the government, but some other less-scrupulous dealers, perhaps they say, the government is on my back, it's time to get out, and I'm going to give a guy like Warren Buffett a call.
There is one other angle, which is probably a bit further out, which is Tesla Motors and their desire to have factory-owned stores rather than use a franchise dealer model like everybody else does. I think realistically, though, that threat is pretty far down the road. Buffett clearly is not concerned about it, given he made the deal. Realistically, Tesla would have to either fight every state's franchise laws one by one, which will take forever (that's what they've been doing), or go all the way to the U.S. Supreme Court, which means you've got to the get the court to hear a case, but then you'd also have to get the court to side with Tesla. I think even if that were to happen, that's very much a ways down the road.
Glaser: With Buffett entering the space, saying he wants to do more acquisitions there, what impact do you think that's going to have? Does it potentially change the landscape? Or is it just one more player?
Whiston: It's one more player, but it's a very big player. I don't think it's going to impact the other public dealers we cover. They are going to be able to continue to grow by acquisitions as much as they like. I have heard, even just very recently, that amongst the dealers I cover, they don't compete with another public dealer when they're out there looking for deals.
It is an extremely fragmented space. AutoNation is number one, as I mentioned, and they only have 1.9% of new vehicle volume. The six public franchise dealers combined only have 5.5%, roughly, of new vehicle volume last year. So having Buffett in there, it's just another player out there to consolidate what has been a still highly fragmented industry that's still consolidating. Around the late 1940s, we had nearly 50,000 dealers in this country. We have 17,600 roughly today.
Glaser: The shares of the publicly traded dealers rallied on this news. Are there any values there, or have they just become too expensive with these big price increases?
Whiston: They were pretty much mostly all 3-stars before the Berkshire announcement on Thursday. Obviously, there has been an excellent "Buffett bounce" in the dealer space both Thursday and Friday. So they're still mostly 3-star, fairly valued. I think we have one 2-star stock.
I can understand the Buffett bounce, but I think it's really speculative to just assume that all the public dealers are now "in play" to be acquired by Berkshire Hathaway. There are a lot of dynamics there. These companies that I cover, they are all quite healthy now. They have their own vision, their own strategy. They don't necessarily need to get involved with Berkshire to do what they want to do.
The tricky thing is, though, that even with some of the large players, they are still family-run businesses--in particular, Roger Penske of Penske Automotive Group, the Smith Family in Charlotte with Sonic Automotive, and the DeBoer Family with Lithia Motors in Medford, Ore. In theory, any of them could just say, I want to cash out now but still have control of my business, and Warren Buffett is a great partner to do a transaction like that, but it's really just up to the whim of the family to sell.
Personally, I am not allowed to buy these stock, since I cover them, but I wouldn't be investing my own money today just hoping Buffett would buy out a dealer. It's a great business, but it's really a sector that is only cheap in a recession. So sometimes you just have to wait for a better time to buy.
Glaser: Are there other places in the automotive space that are more attractive right now?
Whiston: My coverage list is primarily U.S. autos. I cover GM and Ford. They are obviously not for everybody--a lot of headline risk, a lot of volatility. But if you take the time to look at the turnaround story going on at both companies, it's very interesting. The balance sheets of both are also quite fine. In GM's case, they are going to eventually have more bad news from this ignition switch recall, but they have the cash on hand to pay that. They have roughly $39 billion in total liquidity.
In the meantime, if you're a dividend investor who doesn't mind the volatility and the headline risk, you are getting paid to wait. Both companies now yield over 3%. I believe GM is around a 3.6% yield--far north of the S&P 500's roughly 2%.
Glaser: David, I certainly appreciate your update on the auto dealership space today.
Whiston: Thanks.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
