It is undeniable that one of the main parts of an investment thesis implies carrying out a sectorial analysis. Sometimes is rather difficult to forecast which direction a specific sector will follow, but at least it is absolutely essential to understand how the sector is structured, what the most relevant players are and what trends and risks could drive or derail its future performance.
I tend to include this analysis as part of my theses but this time I decided to follow a different approach. Actually I started as always, analyzing one specific company but rapidly realized that automotive dealership is a sector with many nuances and that it was preferably to dig deeper on it before focusing on any specific company. In that sense the idea of this article is to serve as an introduction for subsequent articles in which I expect to analyze concrete public companies within the sector.
Zooming Out Before Zooming In
In order to better understand the automotive dealership sector let’s first zoom out and understand where dealerships are located within the broader automotive sector:
As it can be observed in this chart (which provides just a general overview with some random examples) the supply chain starts with raw material and manufacturing suppliers. Although it’s generally believed that automakers design and manufacture their own vehicles, including all the parts, actually they outsource all kinds of components to other specialized automotive suppliers. Car makers (OEMs), in a nutshell, design and assemble the parts received by their suppliers, which are categorized into 3 different tiers: Tier 1 suppliers refer to those that supply finished parts or specific components for cars; Tier 2 suppliers provide materials/parts to Tier 1s and tend to cater to different industries (e.g. semiconductors); and Tier 3 suppliers provide close-to-raw materials (e.g. steel or plastic), usually to Tier 1s and Tier 2s.
Once vehicles are finished, OEMs hire third-party logistic companies to take care of the transportation and distribution and, more importantly, of the selling process (indeed, as we will see and generally speaking, OEMs are not allowed to carry out this selling process in the U.S.). The dealerships are the ones that take care of warehousing and selling the vehicles to the public, and they also participate in some aftermarket tasks (e.g. auto parts, services, used car market), together with other niche players that complete the automotive sector supply chain (e.g. general repair and collision centers; car wash and auto detailing; or car hires and rentals).
Industry Composition
In the U.S., the franchised automotive dealer industry is one of the largest retail businesses by revenue in a market of approximately $1.6 trillion, however it is still among the most fragmented retail sectors (as it will be further explained in the next paragraph). There are basically 7 publicly held automotive retail groups (Asbury Automotive Group $ABG, AutoNation $AN, CarMax $KMX, Group 1 Automotive $GPI, Lithia Motors $LAD, Penske Automotive Group $PAG and Sonic Automotive $SAH) which “account for less than 10% of total industry revenue”, “with more than 90% of the U.S. industry's market share remaining in the hands of smaller regional and independent dealers”. There are approximately 17,000 franchised automotive dealerships, which sell both new and used vehicles, and 30,000 independent used vehicle dealers.
Key Features of the Industry
· Fragmentation and Consolidation Process
As mentioned in the previous paragraph, the U.S automotive dealer industry is one of most fragmented retail sectors. It is considered that the main reason behind this fragmentation is the “relatively few economies of scale. Dealers all pay the same prices for their vehicles, labor, real estate, utilities, etc. As a result, smaller dealers have been able to effectively compete with larger dealers”.
Being said that, this narrative is changing and “dealers are increasingly convinced that large scale will matter more in the future than it has in the past”. The increased use of advanced technology in vehicles, the need to offer comprehensive and omnichannel shopping experiences, the ability of holding biggest inventories or the capacity to make the investments required to adapt to electrification are just some of the circumstances that are making difficult for small/independent dealers to compete with larger dealerships. This situation is favoring a steady consolidation and invites to think that further consolidation may occur in the future.
However it is important to highlight that consolidation is mainly occurring at the level of owner count, while the store count has largely remained unchanged:
Indeed, according to Mercer Capital, the total number of automobile dealerships or stores has only declined approximately 1.9% from 1970 through 2019. In that sense, they think that this number may stay relatively consistent, while “the trends (they) have seen of smaller stores being gobbled up by increasingly larger auto groups will continue”.
· Highly Regulated Sector
Although later I will also comment this point as a risk in a section below, regulatory intensity is clearly one of the main advantageous features of this sector.
The automotive retail market enjoys substantial legal protections. Probably the best known is the prohibition on automakers of direct selling their vehicles to customers: “In the United States direct manufacturer auto sales are prohibited in almost every state by franchise laws requiring that new cars be sold only by dealers”. This regulation is enacted state by state and each one has its own specificities, but in general terms car dealerships are the only ones allowed selling new cars and servicing them.
Additionally dealer franchise laws establish many other restrictions to auto makers ranging from the provision of exclusive territories for car dealers or the requirement to demonstrate the need to establish a new dealership in a dealer’s area, to franchise agreement termination restrictions or prohibitions on price discriminations among dealers.
The origin of these regulations is in the mid-twentieth century when car dealers were mostly mom-and-pop retailers and the so called “Big Three” auto companies (GM, Ford and Chrysler) were hegemonic firms. It was considered that big manufacturers were taking advantage of dealers in a variety of ways and that those dealers needed some sort of protection, which in the end would result in greater consumer protection. “Among other things, these laws prohibited a manufacturer from opening its own showrooms or service centers and transacting directly with customers. The dealers successfully argued that if the manufacturers were allowed to distribute directly to consumers, they could unfairly undermine their own franchised dealers”. Nowadays the market has completely changed and there are many other manufacturers competing with the “Big Three” (import brands now offer a larger proportion of products and the number of products/models available has increased dramatically). In that sense, currently there are many voices that question the need of maintaining these regulations and even some economists consider “that, as a result of these laws, distribution costs and retail prices are higher”.
Anyway, regardless of whether they are reasonable or not, those regulations, as long as they continue to exist, will serve as a legal entry barrier for new entrants, protecting dealerships from the competition.
· Revenue Structure and Profit Centers
If you asked anyone how they think car dealerships make money, the logical answer would be by selling cars. And this is true but not precise. In general terms, car dealerships offer a broad range of products and services beyond new/used cars. Those “ancillary” services comprise basically vehicle financing and insurance contracts (F&I); automotive maintenance and repair services; and vehicle parts. In fact, although the bulk of the revenues come from selling vehicles, the majority of the gross profit is concentrated in F&I and parts & services. Let’s have a look to some examples provided by public companies:
As it can be observed car dealerships generally make more money on the provision of finance and maintenance services or the sale of parts, accessories and warranties, much more than they do on vehicles sales: only ~35% of gross profit actually comes from the sale of vehicles and ~65% from those other services. This provides dealers with higher resilience during unfavorable phases of the economic cycle, when consumer behavior tend to shift away from new cars but activities like repair and maintenance services, and parts and accessories usually outperform.
Besides this trend toward “ancillary” services has intensified in recent years, being only interrupted by the disruption introduced with the pandemic:
There are two main correlative reasons behind this trend. On the one hand, the new and used vehicle gross profit erosion, with multiple factors contributing to this issue: OEM incentive programs (e.g. stair step programs, turn and earn policies); disruptive new entrants and online players; increased pricing transparency and the ease for consumers to compare prices; higher manufacturers competition; oversupply of new units; slowing sales growth; etc. On the other hand, and probably as a consequence of this compression of vehicle margins, the growing interest dealers are putting on other gross profit streams.
Both trends, sales margin compression and increased focus on ancillary services, may continue in the future, especially if the industry keeps returning to pre-pandemic levels (see Risks section below).
· Flexible Cost Structure and Lower Cyclicality
Generally, car dealerships enjoy rather variable cost structures, with employee compensation and advertising combined implying more than 50% of their SG&A components. The importance of this structure is that it allows dealers to adapt quickly to changes in the retail environment and rapidly adjust their expenses. Look for instance at the following slide provided by Asbury Automotive Group ($ABG) in one of its presentations (that should be read with many caveats, but provides a rough idea about dealerships’ cost structure):
This characteristic, together with the diversified revenue streams commented in the previous paragraph, makes dealerships to be less vulnerable than car manufacturers to declines in new vehicle sales. New vehicle unit sales are cyclical, as it is also, though a little bit less, used vehicle sales, but service and parts sales or maintenance, repair and collision services has historically been less sensitive to the macroeconomic environment.
Industry Risks
· Reversion To Pre-Pandemic Profitability Levels
There is no doubt that the pandemic heavily disrupted both supply chains and the retail environment. In the specific case of U.S. car dealerships, initial store closures and massive shocks to the vehicles demand were followed by a lack of vehicles supply and a strong demand rebound, leading to record high transactional gross profits and F&I income per vehicle sold. Now things are gradually getting back to normal, with OEMs bringing back supply and prices pressured down.
The crucial question is whether manufacturers will seek to keep supply under pre-pandemic levels in the future and dealers will be able to maintain pandemic expense cuts in order to reach a higher profitable “new normal”, or OEMs will return to their typical tendencies of over-producing relative to demand, which in turn could drive significant margin compression. Heightened interest rates, falling demand and new vehicle transactional grosses returning to more normalized levels invite to think in further margins erosion in the near term.
· Regulatory Environment
As commented at the beginning of this article, regulatory intensity is clearly one of the main advantageous features of this sector. The problem with regulations is that are something out the dealers’ control. They depend on political circumstances or even whims, and those are rather unpredictable.
In the specific case of the car industry there are increasingly more voices claiming against franchise dealerships protection and alleging that those are outdated regulations that can negatively affect innovation and new business models. Probably the most known is the battle that Tesla is fighting state by state in order to use a direct-sales model. The automaker is still not allowed to sell its cars without using a franchised dealership model in many states, but many others have recently introduced legislations/amendments to include some exceptions (mainly related with electric vehicles).
Anyway, from an investor’s perspective, probably the right approach is not to try to guess whether politicians will eliminate a specific regulation or not, but what would happen if they actually eliminate it, what would be the impact for the company/sector. In that sense, there are two aspects that invite to be (cautiously) optimistic.
On the one hand it is rather unclear the capacity or intention of many OEMs to really launch a direct selling model. In ATA words, “the sheer investment dollars, in addition to the workforce and operating expertise required to stand up a competitive direct-to-consumer business model casts at least some doubt on the practicality of an OEM direct selling model”. Being a hackneyed claim in many sectors, the disintermediation adds a lot of complexity and, in the specific case of the automotive sector, the vast footprint to be serviced is huge. Many OEMs are far from prepared or willing to take on that role.
On the other hand, it is rather telling what happens in those regions where there are no direct-sales bans, like Europe. It seems that most sales are still made through dealerships:
No country in the world exclusively utilizes a direct sales model for retail automotive sales. While some upstarts like Tesla have adopted that model, all countries still maintain and utilize some OEM/dealership model. While direct sales proponents insinuate that franchise laws are the only thing preventing a shift in the market, countries without these laws do business very similarly. If EVs are going to be successful, it will likely be dealers who have made the investment in personal relationships in their community who can help consumers understand the benefits and challenges of the new technology (Mercer Capital).
In close relation to this issue, many industry experts “predict the agency business model may become increasingly prevalent in the auto dealership industry”. As compared to the traditional model, under an agency model franchised dealerships no longer buy inventory from OEMs and sell it to customers. Conversely, they facilitate the sale of the vehicle providing information and helping the customer in the selling process (as an agent of the OEMs), and receiving a fee in return. While there are many dealers concerned with the agency model, the reality is that early adopters have a rather favorable view of it and might be as profitable as the traditional model: it requires lower financing costs, lower overhead needs and lower complexity, and keeps the possibility of retaining the after-sales business.
All in all, even being the potential elimination of franchise dealerships regulation or the agency model penetration concerning issues which undoubtedly introduce some uncertainties, it is rather unclear if those would radically change the way cars are generally sold or even if it would materially affect dealerships’ profitability.
· Electric Vehicles (EVs)
Apart from the issue commented in the previous paragraph related to electric vehicle automakers trying to override the franchise model, this new technology poses some threats over dealerships business model: it is expected the aftermarket for automobiles will have to transform from one focused on internal combustion to one focused on digital systems and sensors. Besides it is commonly believed that EVs require lower maintenance needs due to fewer moving parts and the no need for certain services designed for Internal Combustion Engine (ICE) vehicles (e.g. oil changes, smog tests, etc.).
However, there are again some caveats that invite to be optimistic. First of all, it is not clear yet the reality with regard to those lower maintenance costs. There are voices pointing in the opposite direction and executives witnessing “that the average repair order of the battery EVs (is) over 1.5x higher than the average internal combustion vehicle”. Anecdotally, “Hertz is scaling back its EV ambitions because of its Teslas’” high cost of repair.
Second, consumers’ appetite for electric vehicles is still limited. While “early adopters” have been responsible for the rapid growth in the previous years, mass market adoption seems more reluctant and the growth is slowing. The lack of a reliable EV charging infrastructure, the anxiety about the battery range or the lack of cheap models are some of the factors that are persuading consumers to stay away. It is expected the rate of adoption to keep growing but probably at a slower pace.
Finally, the most relevant impact is expected to affect mom-and-pop or independent dealerships, compared to larger ones. The increasing complexity of vehicles and the investments needed for facility upgrades and to maintain the expertise and technology to provide a valuable service are pushing back smaller dealerships. This situation could serve as a tailwind for public dealerships which could capture additional market share and favor the consolidation of the sector.
· Autonomous Vehicles (AVs) and Ride Sharing
In line with the previous point, AVs are considered a new technology that could negatively impact traditional dealerships. There is no doubt that autonomous or self-driving vehicles might change the dynamics of vehicle ownership in the future. Although AVs will be probably sold to individual customers, it is expected a relevant part to be allocated to mobility services, eliminating in many cases the need to own a car and therefore lowering car sales. Additionally, those AVs will probably reduce collision frequency, which would presumably have a negative effect over the aftermarket.
However, it is also true that it is increasingly considered that it will take many decades to see the roads full of AVs as the technological, regulatory and economic obstacles are still enormous, and most forecasts are being scaled back. In that sense, being this a real risk for dealerships, its impact will probably unfold far in the future.
With regard to ride sharing, this is also an innovation that could reduce personal ownership of vehicles and so directly impact consumer demand and vehicle sales. However again the reality is in some aspects not unfolding as expected and most people are retaining their personal vehicles, using ride sharing as a complement and not as a substitute. Indeed “some dealers have gained significant business by selling to these commercial drivers and servicing their vehicles”.
Final Comments
The automotive dealership industry is really interesting from an investor perspective as it enjoys many valuable characteristics: it is a fragmented sector that provides multiple opportunities for consolidators (usually, public companies); it is highly regulated, with the positive implications that this provide in terms of protection and barriers to entry; it is diversified in terms of revenues and profits and rather anticyclical (compared to manufacturers); and it generally enjoys a rather flexible cost structure that allows to adapt to different macroeconomic environments.
Additionally this sector is somehow disregarded because there are many megatrends like the electrification, the advent of autonomous vehicles or the ride sharing that are expected to heavily impact the way dealerships are doing business or even could finish them off. However some of those risks could be being exaggerated. Even while it is completely true that the industry faces challenges, like the reversion to pre-pandemic levels or potential regulatory changes, it seems rather prepared to overcome those challenges.
Taking all of this into account, I think it is time to deep dive in some of the public companies that make up the sector. See you in the next article!
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Nice overview. I would add some additional data points. Bilia & GPI have estimated the maintenance cost of ICE vs. EVs using actual data from EV owners & show roughly the same maintenance costs. The service cost of AVs will increase due to the requirement of sensor calibration from any AV system to work. There are economies of scale but they are all local, like management & advertising. This has led to the dealers that are more clustered having higher margins & inventory turns, see Asbury vs. Autonation. Another observation is the low valuations the market has put on auto dealers has made share buybacks very accretive.