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In the midst of a troubled economy the reassurances that strong order backlogs provide are not all they seem
by Russ Mould
Companies with huge order backlogs are often popular with investors due to the excellent earnings visibility they offer, but are they really such safe bets? Against the background of a troubled global economy, it is hardly surprising stocks such as BAE Systems, Babcock International and VT Group have continued to outperform by dint of their huge order backlogs and the reassurance this appears to provide. VT has been dramatically re-rated since its decision in 2002 to move away from the firm’s shipbuilding roots and toward civil and defence support services. A succession of high profile order wins, including the recent Future Strategic Tanker Aircraft (FSTA) deal from the RAF, has taken the Southampton firm’s backlog to £4.7 billion.
Babcock International, which manages the Royal Navy’s Rosyth dockyard, has garnered a £3.3 billion backlog, while BAE Systems’ £38.6 billion order book represents more than twice the firm’s annual sales figure for 2007.
Yet a giant order backlog is no guarantee of share price outperformance on its own and there are three warning signs something could be about to go wrong.
Get the order right
Firstly, a company has to deliver the products its clients have ordered – on time and to the correct specification. Failing to do so can be an expensive mistake. Boeing’s shares had romped up as it received over 800 orders for its new 787 Dreamliner commercial jet. But the Seattle giant’s failure to execute on its now $346 billion backlog has seen its shares slump from a peak of $106.65 to $83 since last October’s admission deliveries would begin later than expected. Further confessions in January and April have seen shipment of the first 787 some 15 months behind the original schedule.
Time to deliver
Secondly, failure to deliver further backlog growth is also a danger sign, as the market will rapidly start to discount and price in a potential loss of earnings momentum.
BAE Systems, VT and Babcock have all consistently grown those backlogs by winning new business. If an order backlog starts to stagnate then a stock will struggle. Semiconductor manufacturing equipment specialist ASM Lithography is a good example. The chart shows how ASML’s share price has waxed and waned according to the development of its backlog, sinking sharply of late, when chief financial officer Peter Wennink revealed backlog had dropped to 60 units by the end the first quarter. This is the lowest figure since the second quarter of 2003 and compares with a cyclical peak of 163 machines in the fourth quarter of 2006.
ASML has continued to win orders from the Taiwanese foundries but has seen manufacturers of commodity DRAM and NAND memory chips ‘push out’, or defer acceptance of equipment already ordered.
Careful attention must therefore be paid not only to the size of the order backlog but its provenance. Persimmon looked an excellent bet when 2005’s £643 million acquisition of rival Westbury went through. The deal left the UK’s biggest house builder with a landbank of 78,000 plots (equivalent to four and a half years’ worth) and forward sales of 7,000 units, against the prior year’s total of 12,636. Yet roll the clocks forward and after last week’s bearish AGM statement, Persimmon now expects volumes to drop 18% and sales 24% in 2008.
At 617p, Persimmon’s shares stand at their lowest level since late 2004, so that once proud backlog was ultimately no defence at all against the turn in the global credit markets.
Failure to disclose
Thirdly, failure to disclose a backlog figure must also be noted, especially in those cases where it has been regularly published before. Antenna specialist MTI Wireless Edge ran up strongly from its March 2006 IPO price of 39p, peaking over 50p in early 2007. Chief executive Dov Feiner’s detailed quarterly updates revealed committed revenues of $3.8 million in the first quarter of 2006 and then $4.1 million in the second quarter, only for the figure to then disappear from quarterly press releases.
When questioned, Feiner has gladly revealed the figure each quarter, so there has been no attempt to wilfully obfuscate. But the backlog figure peaked at $5.3 million in the fourth quarter of 2006, just as the share price ran out of steam, and has remained stuck at around the $5 million level since. Order intake delays have since punctured the £13.4 million cap’s earnings momentum and its shares are now stuck at an all-time low of 25p, despite the payment of a dividend and a share buyback programme.