The evolution of autonomous vehicles will cause major upheavals across the economy over the next few decades, and, despite the incredible level of uncertainty around how it will play out, few argue otherwise. The sheer number of industries that the rise of self-driving technology will impact is mind-boggling. Car insurers may have to switch from insuring individuals for human error to insuring major OEMs for technical errors, which could shift leverage away from insurers and likely lead to lower rates -- and margins. The energy sector could experience a plunge in oil demand as autonomous vehicles fuel a culture of ride-sharing in the near term and go full electric over the long term.
Also likely to face trouble in the looming era of driverless cars is the auto dealership business -- but probably not for the reasons you might think. In fact, what is actually a near-term tailwind for groups such as AutoNation (NYSE:AN), Penske Automotive (NYSE:PAG), and Lithia Motors (NYSE:LAD), among others, could be a long-term headwind.
Pros versus cons
AutoNation is a great example: It's the nation's largest automotive dealer in the U.S. market, boasting more than 260 dealerships and 2016 revenue exceeding $21 billion. There are numerous pros to owning shares of AutoNation or its peers. For example, AutoNation isn't tied to any one brand or market segment for its success. That contrasts with major OEMs such as Ford Motor Co. and General Motors, the fates of which tend to be tied to their trucks and SUVs -- and which, of course, only sell their own marques. That allows AutoNation to be more nimble in reacting to shifting consumer tastes, whether that means emphasizing SUVs over passenger cars, focusing on luxury vehicles rather than entry-level options, or rebalancing its inventory mix of imports versus domestic brands.
However, one of AutoNation's biggest current advantages could turn a bullish investment thesis into a bearish one in the decades to come as driverless vehicles slowly take over the roads. That's because the company generates a disproportionate amount of its gross profits from two business segments likely to be disrupted: parts and service, and finance and insurance.
First, let's look at how AutoNation's revenue is generated: The vast majority -- nearly 80% -- comes from new and used vehicle sales.
A far more modest 20% of revenue comes from parts and service, and finance and insurance. But that scripts flips almost completely when it comes to gross profits.
Parts and service plus finance and insurance generate 70% of gross profits, while new and used vehicles generate less than 30%.
What's the problem?
The reason these two segments are such big advantages and tailwinds for AutoNation now is that new U.S. light-vehicle sales are plateauing. Year-over-year sales are poised to decline, which will making finding top-line growth more difficult for all dealers. However, because the company generates a much smaller fraction of its profit from car sales, those should be more resilient in the near term. That's the sort of story investors love to hear in the cyclical automotive industry.
However, that near-term bullish thesis drives straight into longer-term headwinds when you realize that the ultimate goals of driverless cars include reducing crashes and promoting more efficient travel. Fewer accidents obviously means less need for collision repair, and the parts sales and service work that come with it.
In addition, companies such as Uber, Lyft, and rivals yet to be founded will have massive fleets of vehicles and may opt to service their own, or have partnerships with OEMs, which will move still more work away from smaller dealership groups. It's even possible that as vehicles continue to get more complicated and technology-loaded, dealership groups could face rising costs just to be certified to work on driverless vehicles.
Even further, autonomous vehicles are very likely to become fully electric. Investors have to keep in mind that an electric vehicle motor has a small fraction of moving parts compared to its gasoline powered counterpart. That means fewer parts to wear down, repair or replace, and charge you for, and thus a weaker parts and service business; some estimates project electric vehicle maintenance to cost about one-third that of traditional vehicles.
That's just the potential downside for AutoNation's parts and services. The story is similar for its finance and insurance segment if a significant fraction of coverage shifts from individual users -- whom dealership groups are more capable of financing -- to companies such as Uber covering entire fleets. Those organizations would surely opt to deal with much larger insurance entities.
All is not lost for dealership group investors. In addition to the many advantages listed above, it's possible dealership groups could strike partnerships deals such as the one Avis recently made with Alphabet's Waymo. It's also possible that dealership groups will consolidate, increasing their leverage for financing and insuring the fleets of ride-sharing or ride-hailing companies. But one thing is for sure: The twin segments that comprise dealership groups' biggest profit machines now are looking at a rougher roads ahead -- and that's unwelcome news for their long-term investors.