Backlog

A backlog (also known as an 'order book') represents the total value of confirmed orders a company has received but has not yet fulfilled or billed to its customers. Imagine you own the most popular pizza place in town. The line of people who have already paid for their pizza but are still waiting for it to come out of the oven is your backlog. For a business, this queue of pending work is a fantastic indicator of future revenue. It essentially provides a sneak peek into the company’s sales pipeline. Unlike a sales forecast, which is just an educated guess, a backlog is built on concrete customer commitments. For companies in sectors like manufacturing, construction, or aerospace, where projects can take months or even years to complete, a healthy backlog is a crucial sign of business health, offering investors a degree of visibility into future performance that is hard to find elsewhere.

For the discerning value investing practitioner, the backlog is more than just a number; it’s a treasure trove of insights. A consistently growing backlog often signals a strong competitive advantage, or moat. It tells you that customers are lining up for the company's products or services, even if they have to wait. This high demand suggests the company offers something unique that competitors can't easily replicate. Most importantly, a solid backlog provides predictability. One of the biggest challenges in investing is dealing with uncertainty about the future. A backlog of signed contracts gives an investor a clearer picture of a company’s future earnings and cash flow. This visibility allows you to build a more reliable valuation model with greater confidence, which is the cornerstone of determining whether a stock is truly undervalued. A company with a two-year backlog is, all else being equal, a much less speculative bet than one living hand-to-mouth on next month's sales.

A backlog figure on its own doesn't tell the whole story. To truly understand what it's saying, you need to dig a little deeper and analyze it from a few different angles.

A huge backlog isn't automatically a good thing. It could be a sign that a company is struggling with production bottlenecks and can't deliver on its promises. The key is to put the number in context. A great way to do this is by calculating the backlog-to-sales ratio.

• Formula: Backlog / Annual Sales

This ratio tells you how many years' worth of sales are currently sitting in the order book. For example, if a company has a $2 billion backlog and $1 billion in annual sales, its backlog-to-sales ratio is 2.0x. This means it has roughly two years of revenue already secured. Comparing this ratio to the company's historical levels and to its competitors provides powerful context. You should also investigate the quality of the backlog. Are the orders firm, legally-binding contracts, or are they easily cancellable? A backlog full of flimsy agreements isn't worth much.

A single backlog number is a snapshot; the trend is the movie. You should always look at how the backlog is changing over time—quarter-over-quarter and year-over-year.

• A growing backlog is typically a fantastic sign. It indicates that new orders are flowing in faster than the company is completing old ones, signaling strong and rising demand.
• A shrinking backlog can be a red flag. It might mean that demand is drying up. However, it could also mean the company has become much more efficient at fulfilling orders, which is a positive. You have to look at revenue trends simultaneously to understand the real story.

The importance and size of a backlog vary dramatically across industries. For certain businesses, it’s a critical metric; for others, it's irrelevant.

• High-Relevance Industries: Think of companies with long production cycles. For an aircraft manufacturer like Boeing or a heavy equipment maker like Caterpillar, backlogs represent years of work and are one of the most-watched metrics by analysts. The same goes for engineering and construction firms.
• Low-Relevance Industries: On the other hand, a consumer staples company like Procter & Gamble or a fast-food chain doesn't really have a backlog. Their sales cycle is very short, and products are sold almost immediately. For these businesses, you'd focus on other metrics like inventory turnover or same-store sales.

While a strong backlog is often a bullish signal, clever investors know to watch out for a few potential traps. Before getting too excited, always check for these red flags, usually by digging into a company's annual reports (the 10-K) and quarterly reports (the 10-Q).

• Cancellable Orders: Some companies may include non-binding letters of intent in their backlog figure. A savvy investor should check the fine print to see how much of the backlog is firm versus subject to cancellation.
• Customer Concentration: If a large portion of the backlog comes from a single customer, it introduces significant risk. If that one customer cancels or goes bankrupt, the backlog—and the company's future—could take a massive hit.
• Execution Risk: A ballooning backlog can strain a company's ability to deliver on time and on budget. This can lead to cost overruns that crush profit margins, damage the company's reputation, and ultimately destroy shareholder value.
• Defining “Backlog”: There is no single, universally accepted accounting standard for what constitutes a backlog. Companies have some leeway. Always read the “Management's Discussion and Analysis” (MD&A) section of financial reports to understand exactly how the company defines and calculates the number.