Once again, our local meteorologists were a little wide of the mark with their forecast last weekend. Waking up to predictions of wind and thunderstorms, I decided to cancel my fishing trip. You can probably guess the rest. There were about four or five raindrops, after which the clouds parted and the sun emerged. So I spent much of the day doing yard work instead.
It's nobody's fault. Even with the latest instruments and computer models, weather forecasting is still somewhat of a guessing game.
The same could be said for financial forecasts involving a company's future earnings. Numerous capricious variables play into the bottom line, so trying to nail down a forecast with any degree of precision is often a difficult task. Even management (which is in constant discussion with customers and has a birds-eye view of the entire organization) is often a little vague on the details.
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Consider Ford Motor (NYSE: F). The latest guidance calls for 2019 EBITDA to land anywhere between $7.0 and $7.5 billion. That's a fairly wide $500 million cone of uncertainty. Keep in mind, the first half of the fiscal year is already in the books, so management is only attempting to peer ahead six months into the future.
To be fair, Ford is by no means the only company that wants to leave itself a little wiggle room.
Many unpredictable factors can nudge (or even shove) the final number one way or another… from raw materials inflation to foreign currency fluctuations to the impact of tariffs. And the outlook gets hazier as we look further ahead. Among the Wall Street analysts who follow Apple's (Nasdaq: AAPL) every step, some expect 2020 earnings to be as weak as $11 per share, others as strong as $14.
They are all over the map.
Earnings forecasts are seldom an exercise in precision. And for some inscrutable companies, the outlook is about as clear as mud. As an analyst, that makes my job tougher, considering future earnings and cash flows not only dictate dividend distributions but are also a key determinant in stock prices.
All things equal, the clearer the earnings visibility, the more comfortable I am holding the stock.
And that's exactly why I'm so enthusiastic about my most recent Daily Paycheck recommendation. With this particular business, we have the luxury of knowing (not projecting) that a good chunk of future sales and profits are already in the bag. You see, they've already happened but just haven't been counted yet.
That makes things altogether simpler -- a bit like forecasting yesterday's weather.
The Comfort Of A Backlog
Take most businesses… a coffee shop, auto dealership, hardware store. They all start each new quarter with the cash registers at zero. The best they can do is estimate how many lattes or sedans or hammers will be sold over the next 90 days. But demand can (and does) change quickly. How many times have we seen a stock plunge because of a downward revision to sales and earnings guidance?
But some don't really start the quarter at zero. They know in advance that a certain number of widgets are already in the sold column. Any new sales will only add to the total. How? Because there are previous orders still in the queue. The company has simply been too busy to manufacture and ship the items. In other words, the company is sitting on a stack of confirmed purchase orders and only needs to deliver the merchandise for the sales to be recognized on the income statement. Converting this backlog into revenue is often just a matter of weeks or months.
One of my favorite examples (despite recent missteps) is looking at nearly half a trillion in future sales. This isn't some kind of projection or guidance figure -- anybody can do that. No, we're talking about a done deal, money in the bank (well, soon to be, anyway).
I'm referring to Boeing (NYSE: BA), which has a colossal work backlog of 5,500 commercial and military planes worth $474 billion. For perspective, the company typically delivers approximately 900 jets worth $100 billion annually, so this backlog is equivalent to five years' worth of future sales. These signed and sealed orders have already been placed by customers such as China Airlines and British Airways. They are contractual in nature. So the guesswork has been taken out of the equation. It's just a matter of manufacturing the planes and shipping them out the door -- or hangar, as the case may be.
"Backlog" is defined as sales orders that have been received, but not yet fulfilled. Call it a head-start on the next quarter or next year. This unfinished work has built up because Boeing consistently has more demand than it can handle (not a bad problem to have) and must put some of it on the back-burner for later. Even if Boeing fails to attract a single new customer over the next few years (unlikely), there are still contracted sales for 5,500 planes on the books to carry it through. This backlog is highly visible, quantifiable, and predictable.
It's the closest thing we have to a crystal ball.
There are others, of course. For example, Lennar (NYSE: LEN) built 12,700 new homes last quarter but received orders for 14,500 more. The company has received orders faster than it can fulfill them – driving the backlog up to 19,061 homes worth $7.7 billion. This backlog would gradually be whittled down if not replaced by fresh incoming orders. But at least we know that the company will haul in $7.7 billion in sales between now and then, helping to keep cash flows on an even keel until business recovers.
You might think of order backlog as a rainy day fund. And it can serve that purpose if need be. But there are no clouds in sight right now for Lennar. It received orders for 45,826 new homes last year, an increase of 50%. Still, having these guaranteed revenues on the books is reassuring during shaky economic conditions. Backlog-heavy companies such as IBM (NYSE: IBM) and defense contractor General Dynamics (NYSE: GD) have managed to not only maintain dividends during lean times but increase them – both hiked payouts even during the harsh 2008/2009 recession.
Now, that doesn't mean these companies are completely immune to recession. They aren't bulletproof. During a slowdown, they will see a slump in new orders just like anyone else. But here's the difference -- they at least have a pipeline of existing product orders that will continue to feed revenues and earnings for a while.
And that brings me to my second point.
Monitoring changes in backlog can also yield important clues regarding product demand and underlying business trends. And that's exactly what attracted me to my latest Daily Paycheck portfolio addition.
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After a lull, orders are once again on the upswing. Its backlog currently stands at 23,000 units worth nearly $3 billion. And management expects the second half of 2019 to be 35% busier than the first.
That's not all. The company has also just finalized a major restructuring, an event that often unlocks shareholder value and becomes a catalyst for share-price gains. That's not just idle talk. Among all industrial stocks with market caps above $1 billion, this one returned the most capital through dividends and share repurchases last year as a percentage of its size.
Distributions have soared by more than 80% since July 2018. We haven't seen the last of the dividend increases – and I plan to be on board for the next one.