AutoNation (AN) is the country's largest automotive retailer. Is it a worthy investment vehicle? And is it a good way for long-term investors to capitalize on the cyclical recovery now under way in the broader auto industry?

The Auto Business: A Quick Review

Like many of America's top industries, the auto sector was hard hit by the recent financial crisis and deep recession. In fact, new car sales in the United States hit a 27-year low in 2009 (of just 10.4 million units), despite historically low interest rates and the successful "Cash for Clunkers" stimulus program. And two of the country's largest auto makers, General Motors (GM)  and Chrysler, needed billions in government bailouts in order to stay afloat and reassert themselves in the increasingly competitive global marketplace.

Today, things are looking markedly better in the automotive space. While domestic new vehicle sales are still a far cry from the 17 million units sold annually between the peak years of 2000 and 2007, they are gradually recovering from rock-bottom levels, thanks to a more favorable macroeconomic backdrop and a partial easing of consumer-lending standards. (Total light-vehicle sales are headed for a 10%-plus rebound in 2010, to around the 11.5-million-unit mark.)

This upturn ought to lift the fortunes of the revitalized Detroit auto makers, which, under pressure from Uncle Sam, have worked hard to pare their bloated fixed-cost structures over the past several months. It should also help one of our favorite specialty retailers, AutoNation.

Let's Dig Deeper

AutoNation, based in Fort Lauderdale, Florida, is the largest publicly traded dealership group in the United States, with roughly 250 new-vehicle franchises located in major metropolitan markets, mostly in the Sunbelt region. More importantly, in our view, the company is one of the best-managed, most-profitable auto retailers in the sector, primarily because of the veteran leadership of CEO Mike Jackson and its commitment to being the lowest-cost operator in each of its service territories.

This explains, we think, why AutoNation's bottom line remained firmly in the black throughout the severe industry downturn, notwithstanding the firm's high exposure to states, most notably California and Florida, that have been virtually decimated by the housing collapse.

And the company's solid execution, lean cost structure, ongoing productivity initiatives, and big scale advantages over rivals (e.g., CarMax (KMX), Group 1 Automotive (GPI), Sonic Automotive (SAH), Asbury Automotive Group (ABG), and Penske Automotive Group (PAG)) should serve it well as the new car market slowly turns around. Indeed, we think that the retailer will benefit from much greater operating leverage and earnings power as the sales environment warms up in the years ahead.

AutoNation, meanwhile, continues to diversify its business, an effort that ought to make it less vulnerable to unpredictable economic cycles as the decade progresses. In particular, the company is beefing up its used car operations, which now account for nearly one-quarter of total revenues. ("Certified Pre-Owned" programs, which continue to be well received by cash-strapped consumers, have been a boon for the used car segment.)

It is also pushing deeper into high-margined nonvehicle product lines, such as parts & service and finance & insurance, and looking to modify its brand mix. Instead of depending so heavily on the domestic OEMs, as it has done historically, the company is endeavoring to carry more popular foreign cars and premium/luxury brands.

In fact, AutoNation, equipped with robust free cash flow and a sound balance sheet (with a comparatively low debt-to-capital ratio), is active on the acquisition front in search of premium/luxury brand stores that will expand its inventory portfolio, fill out its geographic footprint, and help it gain market share and realize greater economies of scale in key expense areas, like advertising. We expect this mission to bear a lot of fruit in 2011 and beyond, in light of the still-fragmented state of the roughly $1 trillion domestic automotive retailing industry. And, given the company's focus on profitability, we anticipate that any future deals will boost margins and be nicely accretive to share earnings.

All in all, we think that AutoNation is an excellent retail outfit and a fine way to play the expected turnaround in the auto sector. Buy-and-hold investors may wish to wait for a slightly more attractive entry point, however, since a measure of the bottom-line growth we envision through 2013-2015 is already reflected in the stock price.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.