I find that backlog accounting is best explained by the home builder industry. A backlog represents work that needs to be performed but has not been recognized as revenue yet.
As an example, a customer who is approved for a mortgage on a new home goes into a home builder’s backlog. Once that transaction closes, the customer’s purchase is added to revenue and removed from the backlog.
Keep in mind that this is in contrast to deferred revenue, where revenue is recognized but not yet delivered.
Because backlog is not recognized as revenue, it is not an official GAAP metric and not required to be disclosed in company annual reports (10-k).
Here’s an example of a computer company Dell ($DELL), and their 10-k disclosing the significance of a backlog to their business:
“Product backlog represents the value of unfulfilled manufacturing orders. Our business model generally gives us the ability to optimize product backlog at any point in time, for example, expediting shipping or prioritizing customer orders toward products that have shorter lead times. Because product backlog at any point in time may not result in the generation of any predictable amount of net revenue in any subsequent period, we do not believe product backlog to be a meaningful indicator of future net revenue. Product backlog is included as a component of remaining performance obligation to the extent we determine that the manufacturing orders are non-cancelable.”
You’ll find that most businesses report backlog in their 10-k in this way.
However, some businesses do typically report backlog as it can be a great indication of forward demand, and can serve predictive power to short term future revenues.
Let’s go back to home builders, a great example of disclosed backlog accounting in a 10-k. I’m going to share disclosures from PulteGroup’s ($PHM) latest 10-k.
Under the “Sales and marketing” section of the Homebuilding Operating segment overview, Pulte talks about how their contracts with customer include provisions.
Such provisions can include the requirement of the buyer to sell their home, or be approved for financing in a time window or desired interest rate. In the case that such a provision is broken, the contract typically can be cancelled with no penalty to either the home builder or home buyer—in which case backlog doesn’t convert to revenue and instead gets removed with no other impact to the financials.
You can see that the reporting of a backlog is a natural byproduct of the longer sales process of buying and financing a home.
But Pulte also discloses that they expect most of their backlog to be closed in 2020, which is the next fiscal year following the examined 10-k report.
Now let’s look at PHM’s backlog chart. From the 10-k:
You can see how backlog meaningfully picked up in 2019 after a stall in 2018. The company explains that in this instance, the reduction in the backlog did reflect softness in revenue for the upcoming year. As quoted:
“We entered 2019 in the midst of an industry-wide softening in demand that began in mid-2018. To varying degrees, the slowdown occurred across all major buyer groups and substantially all of our geographies. This slowdown was correlated with an increase in mortgage interest rates, which contributed to ongoing affordability challenges confronting many prospective buyers. As a result, we entered 2019 with a smaller backlog than the year before.”
Looking at the company’s income statement, we can see that revenues from the homebuilding segment was flat to slightly down from 2018 to 2019, from $9,983 million to $9,979 million.
But as demand strengthened throughout the remainder of 2019, the company’s backlog swelled up again. It likely indicates a strong revenue profile for the company in 2020, assuming that normal business conditions continue (writing this with the benefit of hindsight, we know that the company was about to face very abnormal conditions in just a few months to follow).
Management’s additional comments, to show how the backlog situation led to improvements in new orders (to eventually be converted to revenue):
However, demand improved in mid-2019 as we experienced increased traffic to our communities and higher new order volume relative to the same period in 2018. The improvement continued through the remainder of 2019, especially among first-time buyers, in part due to improving affordability driven by increasing wages, slower price appreciation, and a decline in mortgage interest rates. Based on these favorable economic factors and our investments in new communities, we were able to generate a 9% increase in new orders and a 20% increase in ending backlog in 2019 compared with 2018.
The company also reported additional details on the backlog, with dollar values and units as the following:
- Units: 10,507
- Value: $4,535,805
- Units: 8,722
- Value: $3,836,147
Knowing the basics of the backlog’s relationship with revenue and (future) demand can help analysts wishing to understand a company and its financial results better.
It’s not an end-all, be-all figure, and doesn’t always perfectly represent or forecast demand accurately.
But, it can be an important proxy, especially in industries like home builders and another manufacturing companies with longer delivery times.
Note the key difference between a contract that gets put on the backlog and a contract in which revenue is recognized, and you’ll understand whether to focus on a company’s backlog or deferred revenue.
After you’ve mastered backlog accounting, what’s next?
Taking this question in the context of the home builders industry, which is how I’ve decided to explain this topic today, I’d say that understanding the overarching conditions which affect the industry is the next (and first) logical step in analyzing the business of a home builder.
Those sections have valuable insights straight from the mouth of leadership, who could have decades of experience in the industries and companies you are looking to invest in.
Once that picture is absorbed, and you’ve created an industry map, it’s time to dig into the financials with key metrics and formulas. A few other ideas to get you started:
There’s a lot of resources that I’ve just linked for you there, but that’s because there’s lots of parts of a business that make the gears spin.
Like with the backlog, each can give you an insight into the company’s future demand and growth potential based on what the company has done so far.