The Business Of

Cars | AutoNation | What Are Their Margins?

Morning All!

So, yesterday we dug into how AutoNation makes money. And we saw that the company sold ~230k new cars and ~300k used cars in 2022. We saw that the average new car sold for ~$51k and the average used car sold for ~$26k. And this meant that the company made a whopping ~$12bn from selling new cars and ~$10bn from selling used cars!

But anyway, that’s enough about revenues. Today, let’s switch our focus to margins and start by looking at how AutoNation’s cost structure is split…

We can see that a massive 87% of AutoNation’s costs come under the ‘Cost of sales’ bracket! And so, as you can imagine, we’re going to focus pretty much solely on this cost line today.

But just before we get going, I want to quickly look at the chart below. The chart shows us what AutoNation’s gross margins are across their 4 segments; (i) new cars, (ii) used cars, (iii) repairs and service, and (iv) finance. And we see quite a range. One segment has a gross margin of just 6%, whilst another segment has a 100% margin!

We’ll see which segment is which at the end of today!

And this is so important to understand! Because whilst AutoNation makes ~80% of their revenue from selling cars. They make less than 40% of their profits from selling cars! Crazy I know! And with that… let’s crack on with the first segment!

Oversupply Has Been Hurting Gross Margins For A While!

Okay, so the first segment we’ll look at is new vehicles. And what do we know so far? Well, we know that AutoNation buys new cars from car manufacturers (like Toyota and Ford). And they then sell these new cars to us. We saw yesterday that the average revenue per new car is ~$51k.

But here’s a question - how much do AutoNation pay car manufacturers to buy those new cars from them?

Well, by looking at AutoNation’s annual reports, we can see that the average amount that AutoNation pay manufacturers for their new cars is ~$45k.

So, what does this mean? Well, it means that AutoNation’s dealerships make a gross profit of ~$6k for every new car they sell. Which works out to a gross margin of ~12% per new car sold ($6k/$51k).

Now, AutoNation will want that gross margin to be rising. Because this will mean more profit every time they sell a car. HOWEVER, as the chart below shows, new vehicle gross margins have been declining pretty consistently ever since 2000!

So, there’s a couple of questions here - firstly, why have gross margins been declining so consistently? And secondly, why did they pop so much from 2020-2022? Well, to answer the first question first - one of the main reasons gross margin has been declining over the years is the bad habit of overproduction in the car industry.

What do I mean? Well remember, car manufacturers like Ford make their revenue when they sell to dealerships. And so for years, Ford and other manufacturers wanted to sell as much as possible to dealerships like AutoNation to increase their revenue. HOWEVER, what happens when there’s so many cars at dealerships… and not enough customers to buy them? Well, dealerships have to start lowering the prices of their cars to try and sell them! As the table below shows us, the price that AutoNation has paid to buy new cars from manufacturers has grown at ~2.6% per year from 2000-2019. But the prices at which they could sell these new cars only grew at ~2.3%. Small differences - but big impacts on gross margin!

AutoNation’s CEO actually spoke about this oversupply issue in this article here for those of us who want to do a bit more reading on the topic! Alrighty, let’s move onto the second question - why did gross margin pop in 2020-22? Well, the answer is because of something we saw yesterday - new car prices have jumped ~30% over the last 3 years! From ~$39k in 2019, to ~$51k in 2022. (Check back to yesterday’s newsletter to see why!)

However, crucially, the prices that AutoNation’s dealerships BOUGHT the cars from the manufacturers like Ford and Toyota didn’t jump as much! And so, when costs rise less than revenue, what happens? Margins go up - happy days! We’ll touch back on this point in just a moment…

Used Car Prices Have Exploded… But So Has The Cost Of Buying Them!

Okay, let’s move onto the user car segment. And remember, when we talk about used cars - AutoNation aren’t buying these cars from manufacturers like Ford and Toyota. They’re buying these cars from individuals at trade-ins. And from vehicle auction houses - like Manheim. Check back to yesterday’s newsletter if you need to jog your memory here!

And so, same question we asked before - how much do AutoNation pay at trade-ins and vehicle auctions to buy their used cars?

Well, again, looking at AutoNation’s annual reports, we can see that the average amount that AutoNation pay to get their hands on these used cars is ~$28k.

So, what does this mean? Well, like we saw earlier - it means that AutoNation’s dealerships make a gross profit of ~$2k for every used car they sell. Which means a gross margin of ~6% per used car sold ($2k/$30k).

And again, despite AutoNation ideally wanting these gross margins to go upwards. The chart below shows us that used car gross margin has declined steadily from 11% in 2000 to just 6% in 2022!

So, there’s a couple of questions here - firstly, why is gross margin for used cars vs new cars usually higher? And why didn’t used car gross margins pop during 2020-2022 like we saw for new cars? Well, to answer the first question - a part of this comes down to differences in bargaining power. When AutoNation buy new cars, they’re buying from car manufacturers like Ford and Toyota. Huge, huge companies that have much more power in negotiations vs dealerships. And so it’s these manufacturers that are really setting the prices.

However, who do AutoNation’s dealerships buy used cars from? Well, as we’ve said, a lot of the time, it’s individuals who are deciding to buy a new car and are just trading in their old car. And who’s the bigger player that holds the power in negotiations here? It’s the dealership! And so in the used car space, it’s the dealership that’s often setting the prices in their own favour.

Okay, let’s look at the second question - why haven’t used car gross margins popped like we saw for the new cars? Well, for new cars, the prices they sold their cars at rose sharply in 2022. But the price they bought the cars from manufacturers didn’t rise as much. What about for used cars?

Well, for used cars, the prices that AutoNation sold their used cars also jumped. We saw yesterday that used car prices had increased a whopping 38% from $22k in 2020 to $30k in 2022. But there’s a slight difference. The prices that dealerships BOUGHT the used cars at also jumped! Because of the rising price of used cars, AutoNation’s dealerships have been desperate to buy more used cars (from auctions and trade-ins), so they can then sell them at the higher prices and make more profit! However, what’s happened is that MOST US dealerships have thought the same thing and hence bid up the cost at auctions! So, as the chart below shows, the cost of actually buying used cars has increased more than the price at which dealerships can sell them! And what happens when cost rises more than revenue… margin falls!

75% Of Car Purchasers Like Going Back To Their Dealership For Repairs!

Okay, so now let’s look at repairs and services. First off, what does AutoNation actually mean when they say repairs and services?

Well, we’ve seen this week that in 2022, AutoNation sold ~530k cars (~230k new, ~300k used). But here’s a question - after AutoNation sells those cars, is that the end of their contact with those purchasers? Well, the answer is no! Because those ~530k cars will all need repairs and servicing at some point! It’s a bit more sophisticated than what’s going on below…

What kind of repairs and service am I talking about? Well, according to research done in 2017, the most popular service procedures for a car are oil changes, wiper blade replacements, and air filter replacements. Some car owners will also buy parts (e.g. air filters and car batteries). And all car owners will need to get their car thoroughly inspected at a car service.

Now, AutoNation’s dealerships make money by carrying out these car services and selling parts. According to this article, the standard car service cost in America is ~$700! But the question we’re really looking at today is - what are the costs and the margin of this repairs and services segment? Well, as the chart below shows us - it’s pretty high! AutoNation’s repairs and services segment made a gross margin of ~46% in 2022… miles above the margin their car selling segments made!

So, the question is - why does AutoNation’s repairs business have a much higher margin? Well, one of the main reasons is because car purchasers are relatively price-inelastic when it comes to the services part of things vs when they’re actually purchasing a car. What do I mean?

Well, according to this survey, ~75% of car purchasers will go back to the dealership they bought their car in, when they need to get repairs or a service. Even when they could go to third-party car repair shops and get a cheaper service! Most people prefer the experience and feel of going back to where they first bought their car. And because of the reduced emphasis on price, dealerships are able keep their prices high and enjoy healthy margins!

Car Borrowing Has Grown Quickly… Very Quickly!

Okay, so to wrap up - let’s quickly touch on AutoNation’s finance segment. Now, first off - what does ‘finance’ really mean? Well, it’s AutoNation basically helping their customers FINANCE the purchase of their vehicles by offering loans. And AutoNation will make revenue by charging interest on these loans.

So, why are these loans important? Well because most people don’t have $51k in their bank accounts - which is what we saw yesterday that the average new vehicle costs! In fact, in 2022, a whopping ~92% of new cars in the UK were purchased using finance agreements. Now, we’ve seen higher car prices over the last couple of years. We’ve seen higher interest rates. What has this meant for car borrowing? Well, we’ve seen an absolute explosion in car debt and this article is a great read for anyone wanting to learn more about the (perhaps worrying) rise in borrowing!

Okay, so AutoNation makes money in this segment by charging interest. But what’re the costs involved here? And what’s the gross margin? Well, as the chart below shows… AutoNation’s finance segment has a gross margin of 100%! There appear to be no costs!

But how is this possible? Surely there’s some costs for this finance division right? Well, you’re right - there are some costs. In fact, there’s two clear costs. One, the employees who offer the car purchasers their loans get paid salaries - that’s a cost to AutoNation. And two, AutoNation has interest costs. And this is similar to what we saw in The Business Of Banking. Where does the loan that goes to customers actually come from? Well, AutoNation will borrow money from banks at a low interest rate (their cost). And then charge customers a higher interest rate (their revenue).

Okay, so we’ve said AutoNation’s finance segment do have costs - so why does the chart above show a 100% margin?! Well, because remember, the chart above is showing GROSS MARGIN, not EBIT MARGIN (which we’ll come onto in a moment). AutoNation’s employee and interest costs are operating costs, not ‘cost of goods sold’. To learn more about this - I’d recommend checking out this simple Investopedia article!

AutoNation Makes More Profit From Repairs Than From Selling Cars?!

Okay, we’ve covered a heck of a lot today! Let’s wrap up. And first off, let’s reveal the hidden segments from right at the beginning of today’s newsletter!

Now, for those of us who’ve made it this far in the newsletter (well done!), you’re in for a treat. Because the above chart so important when understanding AutoNation. Why? Well, because remember - REVENUES don’t give us the whole picture of a company. We have to look at MARGINS. We saw yesterday that 44% of AutoNation’s revenues come from selling new cars. And 36% come from selling used cars. See the chart on the left below.

But because of the low gross margin of these segments, new cars and used cars only contribute 26% and 11% of gross profit! The chart below shows us that quite incredibly, Repairs and Service is actually is the biggest contributor to AutoNation’s gross profit! Making up ~36% of the company’s gross profit! How WILD is that! See the chart on the right below.

And this is similar to what we saw in The Business Of Cineworld. Cinema operators make most of their REVENUE from selling movie tickets. But because of the low margins on tickets and the high margins on selling food and drink, cinema operators make a big chunk of their PROFITS from food and drink!

Now, if we take off AutoNation’s other operating costs - like marketing, employees, etc. - we get to their operating profit (EBIT). And the chart below shows us what the company’s EBIT margin has looked like since 2000.

And we see an incredible amount of consistency here. From 2000 to 2019, AutoNation’s EBIT Margin stayed within a super tight range of 2.8%-4.3% in every year except 2008 (when the financial crisis hit)!

Yes 2.8-4.3% is very low. But it’s very, very consistent. And as we’ll see tomorrow, this consistency in profitability is something that’s allowed AutoNation to be very consistent with how they spend their profits too!

17th Jan 2024

Nigel Jacob CFA