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Moats Drive Auto Dealerships
The dealers are the only auto sector we cover in which all firms enjoy an economic moat.
Many investors believe the automotive industry lacks competitive advantages, but we contend that each of the public auto dealership companies we cover has a narrow economic moat. The dealers may be off some investors' radar because of their relatively small market caps, but we think their moats are quite strong.
We see the public dealers as long-term beneficiaries of continued consolidation among franchised dealers as smaller players continue to exit, enabling more market share gains, scale, and intangible advantages from the service business and optimal inventory allocation.
Parts and Service Create Pricing Power and Good ROIC
We think the dealer sector is the best business in the automotive supply chain from a competitive advantage perspective. We see all the franchise dealers we cover having two moat sources: cost advantage and intangible advantages.
The public dealers centralize back-office operations and generate far more volume than a small dealer, which brings scale. Dealers have no burdensome retiree expenses, and the large public dealers do not depend on the health of one brand. The dealers enjoy mid- to high-single-digit gross margins on new vehicles and 100% gross margin on financing and insurance. Mergers and acquisitions also help a dealer's cost advantage and intangible advantage. The growing size of a dealer's store base enables more of the scale advantage above as well as more efficient allocation and pricing of inventory than a small dealer. For example, a dealer with many stores can take a used Toyota Camry traded in at one of its Ford stores and send that Camry to a Toyota store in another part of town.
That said, we think the best source of competitive advantage is the parts and service operations, since the warranty gives the dealer an intangible advantage over an independent garage. Many customers bring their vehicle to the dealer for servicing because the vehicle is either under warranty or because the dealer is close to home and has the factory parts and expertise to service the vehicle. Once vehicle owners know a dealer, we think they are likely to keep going back to the dealer for service. The dealer knows the vehicle, and comparison-shopping for repair work is very time-consuming since the customer has to take the vehicle to each shop to get a quote.
These logistics create inelasticity of demand for service work, which creates pricing power for the dealer and is a source of excellent profit in good times and bad. In fact, during a downturn in new-vehicle sales, dealers generally report higher gross margins due to a favorable mix shift, but then report lower operating margins due to selling, general, and administrative expense deleveraging. This trend occurs because parts and service is very profitable, with gross margins ranging from the mid-40s to more than 50%. Excluding large impairment and restructuring charges, dealers can still report positive EBIT even in a severe recession.
Although most dealerships are good businesses, we think the large publicly traded dealers are best positioned for growth because they can be the most flexible in changing brand mix. In 2013, the largest 125 U.S. dealer groups increased new-vehicle unit sales by 14%, compared with 7.5% for the industry. We also think it is no coincidence that 6 of the 10 largest franchise dealers are public, including 4 of the top 5. This suggests that public dealers have the best capital market access to pursue mergers and acquisitions and fund store renovations. Since 1999, the 10 largest dealers have increased their share of U.S. new-vehicle retail sales.