Here's Why Warren Buffett Is Buying Car Dealerships

CNBCWarren Buffett

Warren Buffett announced Thursday on CNBC that Berkshire Hathaway is buying Van Tuyl Group, the fifth-largest car dealership company in the U.S. The dealership group has been privately owned since 1955, but the first order of business is a name change: It will be called Berkshire Hathaway Automotive.

Buffett isn't done yet. He told CNBC that he may buy even more dealerships. Berkshire Hathaway already owns the Burlington Northern Santa Fe railroad and NetJets. He joked after the announcement that he now has automobiles covered, but of course he already owns almost 33 million shares of General Motors, worth $1 billion, according to Bloomberg.

"This acquisition shows the value and importance of dealerships such as the Van Tuyl Group in the automotive ecosystems," Cox Automotive President Sandy Schwartz told Business Insider. Cox is the parent company of Kelley Blue Book, online car sales site AutoTrader.com, and Manheim, a big auto auction company.

"As we continue to innovate and find more effective and efficient ways to further our industry and serve our customers, it's exciting to have a leader like Warren Buffett be a part of the automotive community," Schwartz added.

So why did Buffett do the Van Tuyl Group deal?

Money!

Nothing complicated here. As Amy Wilson noted in Automotive News in March: "In 2013, the average U.S. dealership produced return on equity of 29 percent, according to the National Automobile Dealers Association. That figure has risen in four of the past five years and is now more than double the 12 percent return recorded in 2008 when U.S. vehicle sales collapsed."

The Van Tuyl Group does $8 billion in annual revenue, so it's likely benefitting from that increase in return on equity.

The Wall Street Journal, in reporting on the deal, pointed out that the company's family owners didn't want to sell to a private equity firm - a firm that would have loved that near-30% return! But a private equity deal would have meant an exit in something like 7 years. The Van Tuyl owners wanted a "permanent home" Buffett said on CNBC.

But the Business Needs Some Help

Return on equity is one thing. Profits are something else. "It's incredibly expensive to sell cars," said Steven Szakaly, chief economist for the National Automobile Dealers Association. He pointed out that a lot of dealerships could benefit from gaining the economies of scale that a bigger company offers - especially for so-called "back office" operations.

The management of the dealership gets to stick around, but Berkshire Hathaway provides much-needed improvements.

"I think a lot of dealers will be happy to have a buyer like Buffett in the market," Szakaly said.

The Auto Market In The U.S. Is Booming

September auto sales weren't quite as torrid as August's - but new vehicle deliveries still topped a 16-million annual pace by a good margin (August came in at a whopping 17.5-million annual pace). The recovery from the dark days of 2008-09 is complete, so Buffett can buy a host of dealerships with limited risk of a major retreat to 2009 sales levels.

Market observers expect sales to remain robust for a while - and then, barring an external shock such as a spike in oil prices or a recession or a big leap in interest rates, settle into a comfortable 15-16 million yearly pace. Buffett already has a hand in the broad, consumer component in the auto market through Berkshire's ownership of insurer GEICO. So rather than play the auto recovery by buying more stock in car companies - and knowing that he doesn't want to gobble up an entire car company whole - he does the next logical thing and starts acquiring dealerships.

Dealerships Do More Than Sell New Cars

Dealer profits also come from the follow-on business: Service and used-car sales (people trade in old cars to get new cars). And then there's the profits they can generate from facilitating financing on new cars and leasing deals. Not to mention insurance (enter GEICO). These are enterprises that have multiple lines of business, each contributing to a healthy bottom line when times are good - and even when times are bad, as people tend to need transportation no matter what the economy is doing.

Dealerships, even thought many are now owned by big dealer conglomerates, are still local businesses. Buffett has shown with his newspaper acquisitions that he likes local when there are compelling business reasons to invest in the idea. A well-run car dealership selling the right vehicles in a community can develop something of a monopoly that's analogous to what local papers can do with local advertisers - a process that's supported by carmakers, who restrict the number of franchised dealers that can sell their cars in a particular region.

Cheap Capital - And More Of It

By owning dealerships, Berkshire Hathaway will be able to use the profits they generate as a source of zero-interest lending to fund new deals - and of course take on additional leverage as needed (at the terms he's accustomed to) to magnify his returns.

Buffett also has the opportunity to use the Van Tuyl deal to almost create more profits. In the aftermath of the financial crisis, as the Wall Street Journal reported in 2011, a wave of consolidation hit the dealer business, meaning that if you survived, you got to sell more cars - and make more money.

If Berkshire Hathaway buys up dealerships, it can effectively absorb its competition and create the conditions for Berkshire Automotive to be even more profitable. Buffett says more deals are on the way, and experts on the dealership business have been pointing out on Thursday that the industry is fragmented and ripe for additional consolidation.

"This is going to continue," the NADA's Szakaly said.