Why in the World Is This Hedge Fund Manager Investing in AutoNation?

By Markets Fool.com


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If by now you haven't heard about new-vehicle sales in the U.S. plateauing, then I hope your year-long Netflix binge-watching has been all you hoped it would be.Sadly for auto investors, sales definitely appear to be peaking in the highly cyclical industry, and that has made investors cautious of pouring capital into automotive stocks. Not Barry Rosenstein, though, who founded Jana Partners, as he recently decided to add 3 million shares of AutoNation (NYSE: AN) to the fund.

Why is Rosenstein zigging when most investors are zagging?

Revenue and gross profit tell two tales

There could be a couple of reasons that Rosenstein opted to add AutoNation to Jana's portfolio. While AutoNation remains America's largest automotive retailer, many investors incorrectly assume its business solely revolves around new-vehicle sales.

AutoNation's revenue segments during the first half of 2016 are a tad misleading when predicting its earnings. New-vehicle sales generated 55% of total revenue, while used-vehicle sales generated about 24%. Parts and service generated roughly 15% of total revenue, and finance and insurance contributed a little more than 4%.

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However, the story almost entirely flips when looking at gross profit. New-vehicle and used-vehicle sales generated only 18% and 10% of total gross profit, respectively. Meanwhile, parts and service generated 43% of total gross profit and finance and insurance contributed roughly 27%.

So, one argument in favor of Rosenstein's new position in AutoNation is that, with the stock at a forward price-to-earnings of about 11, the fund is comfortable paying that price for a company that will be more resilient, thanks to its parts and services segment, than most automotive stocks if new-vehicle sales indeed plateau in the U.S.

Size does matter

There are advantages to being America's largest automotive retailer. One is that a dealership network the size of AutoNation can move inventory to different stores in different markets to take advantage of changing consumer preferences. For instance, a consumer trying to sell a Mustang in a cold-weather state will likely have to take a lower price because dealerships in that area know it's tough to sell that vehicle in that market. AutoNation, however, can purchase the vehicle and ship it to, say, California, where it has a very large presence, and which is a prime market for the Mustang.

It's because of that dealership network and size advantage that AutoNation can also create an advantage online, something the company is working diligently on. While smaller dealership groups can only do so much online, AutoNation has the capital to create a user-friendly website that provides consumers the ability to complete much of a purchase online, and even have a car shipped to a dealership near them -- which is where having a large inventory across the U.S. turns into a competitive advantage.

AutoNation is a ways off from turning its e-commerce strategy into gold, but Rosenstein's investment in the dealership network could be a sign that the fund believes it might be the only dealership group with a nationwide brand name, capital, and scale capable of succeeding with e-commerce, making it a potential long-term winner.

Serious headwinds

Despite a couple of compelling bull arguments for AutoNation, there are some serious headwinds, too. On one hand, AutoNation's flexibility between automotive brands is a positive. It isn't confined to selling only a couple of brands, as many dealerships are, because it owns dealerships that sell all domestic brands, many Japanese brands, and even European luxury brands.

But despite having a wide range of brands, nearly half of AutoNation's franchises at the end of last year were located in three states: Florida, Texas, and California. AutoNation generated about 65% of last year's total revenue from those three states, and that could be a problem if those states were to take an economic hit as they have in the past during a housing or energy downturn.

In my opinion, if you're looking for long-term value in the automotive industry, AutoNation would be high on the list of possibilities because of e-commerce and the fact that their profits are less reliant on new-vehicle sales. However, if it were my hard-earned dollars, investing in the automotive industry with peaking U.S. sales would be a tough sell. With the perfect storm over the past few years -- pent-up demand, cheap financing, low gas prices, and surging demand for highly profitable SUVs and trucks -- it's difficult to imagine investors couldn't find more appealing growth stories in other industries. Apparently Mr.Rosenstein likes to live more dangerously than I do.

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Daniel Miller has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.