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Is AutoNation Making a Huge Cost-Cutting Mistake?

By Daniel Miller - Aug 22, 2020 at 8:00AM

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AutoNation is axing some of its parts and service business.

The COVID-19 pandemic has forced many businesses in a long list of industries to make difficult decisions. Management teams have had to prioritize and strategize like never before.

AutoNation (AN -0.44%), the nation's largest automotive retailer, is no exception. But what investors might not know is that the company makes the biggest chunk of its gross profit not from selling vehicles, but from its parts and service business. AutoNation just announced it would shut down its collision parts business in a cost-cutting move. Could that be a huge mistake?

Bread and butter

It might surprise investors that while AutoNation is known as the largest automotive retailer in the U.S., its bread and butter isn't selling new and used vehicles. In fact, new and used vehicles only generate roughly 25% of the company's total gross profit. Almost half of AutoNation's gross profit comes from its parts and service business and another nearly-30% chunk comes from finance and insurance. Just take a look at the lopsided amounts of revenue compared to gross profit for each business segment in the charts below.

Chart showing parts and service as the largest gross profit generator at 46% of total.

Data source: AutoNation's 2019 annual report. Chart by author.

Now that you understand how vital AutoNation's parts and service business is to its overall success, it might sound the alarm when you read that the auto retailer is shutting down its collision parts business. But just how important is the collision business itself, and is this a smart move?

COVID-19 woes

The coronavirus pandemic has certainly changed how we go about our daily lives. One of the drastic changes has been fewer miles driven, as many Americans work from home and travel less. The resulting declines in miles driven and collision repair demand put even more pressure on a part of the business that AutoNation said wasn't profitable even before the pandemic.

In fact, while collision repair is a part of the company's very lucrative and important parts and services segment, the collision aftermarket parts business generated less than 1% of AutoNation's parts and service gross profit in the first half of 2020. With miles driven on an uncertain path to recovery during the COVID-19 pandemic, it makes sense for the company to cut costs and remove the unprofitable business, but it does come at a cost. AutoNation will incur roughly $52 million in charges in the back half of 2020, including $12 million in cash. After the closure it expects another $9 million in cash expenses tied to contract obligations.

Row of vehicles at an automotive dealership.

Image source: Getty Images.

Silver lining

AutoNation's cost-cutting move should have sounded alarms for investors to investigate further. However, this strategic decision is a smart move, and it's the latest example of how management is adjusting during unusual times. In fact, AutoNation also noted in July that it would add 20 or more AutoNation USA stores over the next three years, compared to the five stores it now operates. Those stores only sell used vehicles and will be a perfect addition to AutoNation's business at a time when COVID-19 has sent demand for used vehicles soaring and boosted business for used-vehicle retailers such as Carvana and CarMax.

While COVID-19 has put unusual pressure on the automotive industry and forced difficult decisions, the silver lining in the closing of AutoNation's collision parts business is that management is proving capable of adapting quickly to changing consumer demand -- and for long-term investors, that's key.

Daniel Miller has no position in any of the stocks mentioned. The Motley Fool recommends CarMax. The Motley Fool has a disclosure policy.

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