Is traditional automotive retail dead?
Ah, car buying. A dreaded experience for most consumers. The surprise fees, the back and forth haggling, the sales rep stepping away to “get approval from the manager” during a contested negotiation. Why is the largest retail business in the US such a clumsy experience? Why is it so fragmented? And how will the industry be impacted by the rise of models like Tesla, growth in ride-sharing and innovations in used car buying and autonomous vehicles?
Before we go there, a quick history lesson…
The first dealership in the US was founded in 1898 by a salesman from Detroit…
Today, most states have franchise laws that require direct sales to consumers occur through licensed dealerships. Notable exceptions include Tesla, which has infamously eschewed the traditional franchise laws not without some level of controversy.
Automotive retail is a highly fragmented market…
According to IBISWorld, the car dealership industry is the largest retail business in the US, a ~$1.2 trillion annual market with close to 18,000 individual dealers selling ~17 million new vehicles each year.
The top 10 dealer groups, six of which are publicly traded, own less than ~10% of the entire market and the top 100, less than ~25%. The rest are mostly owned by individuals with just a single or handful of locations.
Dealerships remain a fragmented market because every acquisition or sale requires consent from the Original Equipment Manufacturers or OEMs (e.g., Honda, Toyota, etc.), which prefer long-term capital partners vs. traditional private equity buyers.
In 2015, Warren Buffett’s Berkshire Hathaway acquired The Van Tuyl Group, a portfolio of ~80 dealerships in the industry’s largest transaction in history. Berkshire’s permanent capital vehicle is the ideal steward for an automotive retail business given several industry dynamics.
The Van Tuyl Group enjoys excellent relations with the major auto manufacturers and delivers unusually high volumes at its 78 locations. This is just the beginning for Berkshire Hathaway Automotive” ~ Warren Buffett
The backbone of profitability has less to do with car sales than you’d think…
While it is true that dealership revenue is highly tied to economic cycles, almost ~2/3 of the profitability of dealerships comes from a) Parts & Service (P&S) and b) Finance & Insurance (F&I), two high margin lines of business in nearly every franchised dealership.
Parts & Service (also referred to as “After-Sales”): Automotive repair and maintenance services as well as wholesale parts and collision
Finance & Insurance: Commissions received from arranging loans or leases between consumers purchasing a vehicle and third-party lenders
Example breakdown of gross profit from the sale of a 2020 Nissan Sentra:
F&I is largely tied to sale volumes while P&S is driven by the size of the existing vehicle fleet, or cars sold in the last 0–5 years which remain under warranty. P&S has demonstrated consistent topline growth, even during periods of economic duress.
COVID has caused a “one-time” unsustainable profitability bump…
There’s no question, the pandemic has pulled forward earnings for the industry and profitability has been off the charts from a combination of “stimmy” check demand and constrained supply. Outsized gross margins are commonplace as limited access to inventory given supply chain challenges (most factories shut down during COVID) has given dealers the upper hand in negotiations, with the majority of cars being sold at or above MSRP.
This has translated into strong performance in the public markets, though at some point the music will likely come to an end.
Further, disruptive models are gaining share…
Ask anyone about the long-term risks of the traditional dealership model and several come to mind:
- Autonomous vehicles: Increased car utilization and fewer vehicles on the road. E.g., the average family may not need 2+ cars anymore as just one could drive around all day doing pick-ups and drop-offs
- Ride sharing: Similar to the above, increasing car utilization but to a lesser degree
- DTC sales models: Tesla-like models which sell direct-to-consumer
- Used car marketplaces: Platforms like Carvana, Vroom and Swift which promise a frictionless experience for buying and trading used vehicles online (unfortunately these emerging models lack the high-margin ancillary businesses that exist in traditional retailers)
Despite these headwinds, dealerships generate a ton of free cash flow and are well positioned when it comes to P&S…
While all of these dynamics certainly represent potentially long-term existential risks to the traditional dealership model, well-run auto retailers can be cash cows, generating mid-teens or higher cash-on-cash returns (see AutoNation unit economics below which implies ~24% yield) given their high margin segments, relatively modest valuations and limited CapEx requirements.
Further, the P&S side of the business faces several tailwinds as increased vehicle complexity favors OEM dealerships. Take a mirror, a car part which historically was a fairly simple repair. Today it’s a highly integrated, technical component with sensors, microchips and cameras, requiring a much more advanced skillset to replace than in the past. P&S departments of OEM franchised dealerships will likely be best positioned to perform repairs as vehicle complexity increases, requiring brand-specific parts and certified technicians to carry out the labor.
Where do we go from here?
The automotive industry will be an interesting one to watch as disruptive models take share, franchise laws come under greater scrutiny and consumers demand a better, more frictionless experience. My guess is over time we’ll see dealerships evolve with downsized footprints, greater price transparency and P&S further cementing itself as the bread & butter of these businesses as tailwinds around vehicle complexity materialize.
Thanks for reading, and feel free to share any feedback!
