Why Is Warren Buffett Getting Into the Car Business?

Warren Buffett announced on CNBC that Berkshire Hathaway (BRK.A -0.28%) is going to acquire the Van Tuyl Group, which is the nation's largest privately owned chain of car dealerships.

Source: wikipedia

What is his motivation for getting into the auto sales business? Obviously, he feels there is money to be made, but how much value could there possibly be in the Van Tuyl dealerships for Berkshire?

What is the Van Tuyl Group?
The Van Tuyl Group is the fifth-largest network of car dealerships in the United States, and was founded in 1955 with a single dealership in Kansas City by Cecil Van Tuyl. The business is currently run by Cecil's son, Larry Van Tuyl, who has been involved with the company for more than 40 years.

Today, the business has grown into 78 independently operated dealerships spread among 10 states that combine to produce about $9 billion in annual revenue.

As part of the deal, the business will be renamed "Berkshire Hathaway Automotive," and the current leadership seems thrilled to be joining the Berkshire Hathaway family of businesses.

Why is Buffett interested?
He's interested for the same reason he gets into any business -- he feels there is lots of money to be made.

And the latest industry trends definitely support that. According to data from the National Automobile Dealers Association, the number of car dealerships in the U.S. has dropped by about 11% since 2009, while the average dealership's sales have risen from about $27 million to more than $41 million. And, pre-tax profit margins have risen from 1.5% to 2.2%.

And Van Tuyl's dealerships perform better than most. Some quick calculations show that roughly $9 billion in sales spread among 78 dealerships translates to about $115 million annually per dealership.

So, there is less competition, sales are up, and profit margins have grown. Plus, Van Tuyl has a history of delivering above-average performance. No wonder Buffett wants in.

Just a starting point
The Van Tuyl acquisition could be just the starting point of Berkshire's automotive ambitions. Buffett implied during a recent CNBC interview that he intends to pursue other acquisitions, and to consolidate what is a very fragmented industry. Buffet said that "we will hear, I predict, from hundreds of dealerships in the next year."

Van Tuyl president Jeff Rachor said the new company plans to acquire dealerships in the South and Midwest, where most of the company's current dealerships are located. And, Larry Van Tuyl, who will become Berkshire Hathaway Automotive's chairman, said that there is "a huge opportunity for consolidation in auto dealerships."

Basically, all other things being equal, the larger a company is, the larger the profit margins it can be expected to produce. As operations are consolidated, expenses tend to drop. For example, if two equal-size companies merge, they now only need to pay one CEO, one CFO, and so on.

To fully appreciate the potential here, consider the United States' largest automotive retailer, AutoNation (AN 0.79%), which operates about 270 dealerships in 15 states. Well, in 2013, AutoNation did about $17.5 billion in revenue and earned $604 million in pre-tax income. And, while a 3.4% profit margin might not sound incredibly high, it is more than 50% higher than the average U.S. car dealership. And the bigger it gets, the better the margins can be.

And, given Buffett's enthusiasm when discussing the acquisition, he may have his sights set much higher than 270 dealerships.

What is Buffett's "vision" here?
It's tough to say just how big Buffett thinks Berkshire Hathaway Automotive will get, but from listening to Buffett speak about the acquisition, it appears like they both have some big ambitions for the business.

To give you an idea of just how fragmented the auto sales industry is, consider the numbers. The U.S. market currently has about 17,500 new car dealerships. The company with the largest market share has just 270, or just about 1.5% of these, and has a presence in less than one-third of the states in the country.

In contrast, most other industries have a much more dominant and recognizable leader. For example, the largest grocery retailer (Wal-Mart) has a 25% market share. The largest seller of sneakers (Nike) has a 59% market share.

The point is that Buffett has the power to truly become a game-changer in the automotive sales business. And I'll bet that's exactly what he plans to do.