When the economy turns sluggish, consumers pull back from spending – especially on big-ticket items like new cars. That’s great news for car repair shops, whose technical skills are in demand as owners try to keep their vehicles on the road longer, but it’s not great news for those whose business revolves around selling new or used automobiles, whether they are dealers or auction companies like Kar Auction Services (KAR.N), which generates its revenue from the fees it receives for auctioning off vehicles. And while the company did well in 2011, selling more than 3.1 million vehicles, and although it generated record revenues in the first quarter of 2012 of $506 million, the company’s management has warned investors that results will be weaker in the second quarter. Analysts have responded to that general suggestion (the company didn’t provide any specific guidance) by lowering their own earnings forecasts, but the fact that Kar Auction Services now has a large negative Predicted Surprise of -6.7% signals that they may not have been aggressive enough with those cuts. The size of that Predicted Surprise is a warning sign that when the company reports its second-quarter results in early August, its earnings may well prove to be lower than the current I/B/E/S consensus estimate of 29 cents per share.

Of course, analysts haven’t been standing idly by. As recently as early May, the I/B/E/S consensus estimate for the current quarter ‘s earnings stood at 33 cents a share. In the wake of the company’s earnings conference call May 7, most analysts then lowered their estimates and the consensus dropped to 31 cents within a day. The SmartEstimate, a proprietary StarMine measure that puts a larger weight on the most recent estimates by top-rated analysts with a track record for accuracy, fell still further, to 28 cents. Typically, whenever a SmartEstimate is lower than the consensus, it is a warning sign that the consensus will fall more – and that’s exactly what happened in subsequent weeks, until the consensus hit its current level of 29 cents a share. That is still higher than the 27 cents-per-share SmartEstimate, however, giving the company its large negative Predicted Surprise. That’s a signal that investors should prepare for a negative earnings surprise when Kar Auction Services reports its second-quarter results, and that there’s a reasonably high probability the company will announce earnings that fall short of expectations.

One problem with earnings at Kar Auction Services is that for the last two years, the company consistently has excluded expense items from reported earnings on its press releases, which detail pro-forma results. In the most recent quarter, this enabled the company to report pro-forma earnings-per-share results that were significantly higher than they would have been had Kar Auction Services chosen to highlight its GAAP results. Although the company ultimately beat estimates when it reported pro-forma earnings last quarter, had it used GAAP, it would have fallen short of those analysts’ expectations. The chart below shows the comparison between the company’s earnings using GAAP accounting, and the pro-forma earnings that were highlighted in the company’s press releases. The red bars represent the expenses that investors are being asked to ignore. While higher pro-forma earnings may look good in the short-term, over the long term GAAP usually prevails, making it important for investors to look behind the veil.

Source: Thomson ONE / StarMine

Listening to conference calls or reading transcripts can be very helpful for anyone looking for clues as to how a company’s management views its future prospect. In the case of the Kar Auction Services conference call in early May, analysts were particularly active, peppering executives with questions about the latters’ forecast of second-quarter weakness. For their part, managers offered several explanations, citing seasonal weakness in the second quarter (a somewhat surprising comment, since in two of the last four years, revenues in the second quarter have been higher than those in the first quarter). Good news for drivers – the fact that weather conditions were reasonably good and thus caused fewer accidents – became bad news for the company, as the accident rate affects the insurance auction business. (You can access the full transcript of the conference call on Thomson Reuters StreetEvents).

These reasons may well be valid explanations for what is shaping up to be a weak quarter for Kar Auction Services. Still, investors might well want to dig a bit more deeply in light of the probability that, given the large negative Predicted Surprise of -6.7%, the company will report earnings that fall short of expectations when it announces its results in early August – and perhaps even prepare some questions of their own for management on the next conference call.

 
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