Can you predict future sales WITHOUT accounting skills?
Use information outside financial statements to beat the market
Hi Everyone,
Even if the final and most accurate information about a stock may be found in its financial reports, you can still take a step back and identify signals that lead to those results before they appear in a statement. That’s how I prefer to operate.
There is a lot of literature on non-financial indicators that lead to a company’s success. I covered some of them in previous articles (brand value or company culture for example).
In this post, I want to draw your attention to an indicator of future sales that is often overlooked in investing communities/forums/blogs and deserves more attention in my opinion: Order Backlog.
What is order backlog?
A backlog is the total sale value of all customer orders received but not yet shipped and is a significant leading indicator of future sales and earnings. A backlog exists when a company's production capacity is lower than the rate at which orders are received. A growing backlog suggests a significant order book that will eventually result in future sales or a loss in manufacturing capacity. A diminishing backlog means that sales will eventually decline or that the company's production capacity has increased.
It is, thus, a double-edged sword, yet it provides investors with valuable information about upcoming quarters. For the purpose of equity valuation, knowledge of order backlog has proven useful despite the fact that it is not reported in financial statements. This lack of information hinders investors from making informed selections and at the same time gives them an edge (if they know where to look for it).
What’s the easiest way to find it?
Let’s start with an unexciting but profitable industry: Aerospace and Defense.
If you want to know how LMT 0.00%↑ , RTX 0.00%↑ and NOC 0.00%↑ are doing, then check out the homepage of the U.S. Department of Defence. They update the contracts they give out daily and it’s the closest thing to looking into the future of a stock that you can get. You get valuable information about the size and durability of the orders. Keep in mind that not only the selling but also the maintenance of the equipment provides those companies with recurring income.
With the majority of stocks, you have to do it the oldschool-way: Earnings calls and quarterly reports. What sounds like a time-consuming task has actually a simple shortcut: Use the Quartr App (it’s free). They provide transcripts that you can screen (just open the search button in a pdf and enter “backlog”, then you can scroll through all the sentences that mention it).
Side note: Be aware that product cycles are linked to the size of the order backlog. When comparing businesses with different product life cycles, it is clear that those with longer product cycles have larger order backlogs, while those with shorter product life cycles have smaller ones. Consequently, the levels of order backlog may not be comparable across industries. Nike NKE 0.00%↑ has a shorter product cycle than Boeing BA 0.00%↑ for example.
Are there other benefits to this method?
I've noticed that during economic downturns, order backlog is a useful indicator for finding strong companies.
A rising tide lifts all boats…only when the tide goes out do you discover who’s been swimming naked.
When conditions are favorable, all enterprises are profitable, but when they deteriorate, many are at risk. As a result, many extremely successful, long-term enterprises realize their greatest profits during low tides, when they capture market share from the nude swimmers. Lookout for companies that thrive during unfavorable times.
But you must exercise caution when assessing this data, as its interpretation is dependent on the reasons why the backlog is larger or smaller. In the manufacturing sector, for example, a firm with increased backlogs may have received a sudden inflow of new orders for which it lacks inventory or production capability. Alternatively, staff shortages or a deficiency of inputs may have hindered output.
Below are some possible reasons for a higher backlog:
"Staff shortage limiting production"
"Increased orders with tight deadlines"
"Surge in demand"
"Supplier delivery delays"
"Lack of raw materials and components"
And here are some reasons for a lower backlog:
"No new business to replace lost work"
"No significant new orders received for several months"
"We are working more efficiently"
"We have taken on extra staff to help reduce the order book pipeline"
As you can see, the answer is not always obvious and depends on context. This is why I usually suggest reviewing the earnings call transcript, as financial journalists and bloggers rarely include this information in their articles.
Nevertheless, if you know the reasons behind the change in order backlog, you’ll get a precise picture of the upcoming quarters you would otherwise miss.
I’ve seen it countless times: A company beats analysts’ expectations, raises guidance, and announces an increase in order backlog due to higher demand, but the stock just moves a lousy +1,5% on that day, although they announced stronger growth.
The next quarter they beat sales expectations and investors are surprised again although the information was available in the prior report.
Final words
Backlog numbers are economically significant enough for investors to consider them when projecting a company's future earnings.
However, it should not be regarded as absolute knowledge, but rather as a component of the puzzle that enables you to make informed decisions. As a savvy investor, you are not looking for absolute answers (like the majority), instead, you are looking for indicators.
Order backlog receives little attention and is therefore a factor that investors might use to their advantage. Equity analysis has many parallels to detective work. After connecting seemingly unrelated pieces of knowledge, you realize that everything is interconnected. This means that even from small bits of information, such as order backlog, it is possible to determine a company's financial health and future.
I hope you learned something today, until the next issue. 👋