Callaway Golf: Reiterate Buy Rating

Excerpts from Gilford Securities analyst Casey Alexander's recent note to clients on Callaway Golf (ELY):

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1. The Economic Crisis Reaches Carlsbad

Callaway Golf Guided down last week in their Q3 preannouncement. As a result we are going to reduce our Q3 EPS estimate from breakeven to a loss of ($0.08) per share when adjusted for one time items. We are reducing our Q4 EPS estimate from a loss of ($0.13) to a loss of ($0.18) per share. This reduces our Full Year EPS estimate from $1.09 per share to $1.01 per share when adjusted for one time items. We are reducing our 2009 EPS estimate from $1.33 per share to $1.15 per share. The damage has been done, and the stock has made new 52 week lows.

2. Rodney Dangerfield?

Management has complained all year that Callaway has not gotten the respect it deserves, given the performance of the company. Unfortunately they shot themselves in the foot by not taking numbers down to a greater degree earlier in the year. Had they done so, they would have more credibility with investors today. We all know about the credit crisis. We all also know that TaylorMade has been hitting aggressive sales targets all year, credit crisis be damned. Our guess is that more than the credit crisis is at work here, but the credit crisis makes a convenient fall guy. Respect or no, our job is to evaluate the situation from here, not spend undue time on a post mortem describing how we got here.

3. The Value Proposition is Here; Price to EBITDA, PE Ratio at Historic Lows

Callaway Golf is trading at 6X EBITDA on this years reduced numbers, and 5X EBITDA based upon our EPS estimate for 2009. The 2009 numbers still bake in very little prospect of pent up demand, which suggests to us that numbers could still end up being low for 2009. The credit crisis will not last forever.

Callaway is selling at a P/E of 9.5X 2008’s EPS estimates with the year three quarters over. The shares are trading at 8.2X our 1009 EPS estimate. Do we have great confidence in our 2009 estimate? It’s hard to have great confidence in anything these days, but that is still a pretty compelling valuation, and given the historic trading patterns, ELY still should work from here despite the new lows.

4. Dangerfield or Not, Callaway Should be Bought In or Bought Out

If Management feels they have not gotten enough respect, or better that the stock price has not gotten enough respect, there is an obvious way to rectify that situation. Buy the company. Surely there are private equity firms out there that would entertain the idea at 6X EBITDA that would do this deal with minimal leverage that could be paid down rather quickly. They can lever it up later when the credit markets loosen up, and pay themselves out a fat recap dividend. And management won’t get respect, they’ll get wealthy. Give me wealthy any day.

If management doesn’t want to entertain this idea, then we would suggest a whisper into the ear of the Winged Goddess of Victory again. We proposed this idea a few short years ago and were summarily dismissed. A marriage between these two brands would actually make a lot of sense. We have always proposed that when you look at the golf equipment industry in a generational sense, that there will only be three or at the most four equipment companies that matter on a global scale 10-15 years from now. A major consolidation would allow for the combination of the sourcing and assembly of components and the combination of golf ball manufacturing operations in order to improve capacity utilization rates and drive the cost per unit produced down. This could allow for the ability to offer premium products at prices somewhat below the competition and allow the combined companies to take significant market share, or to offer those products at similar price points with enhanced margins. Either way the combined companies win. A good credit crisis can make for strange bedfellows.

5. Price Histories Suggest Good Returns From Here

The average return from the Q3-Q4 low to the Q1-Q2 high is 64%. If we assume the low for this period is the current low of $9.05 made in the most recent decline last Thursday, then to reach the average return the shares would have to trade at $14.85 sometime in Q1-Q2 of 2009. A price target of $14.85 would put Callaway at 12.8X our 2009 EPS estimate. This is a 7% discount to the estimated 13.8% EPS growth rate based upon our 2009 EPS estimate. The shares would then trade at a very reasonable 7.4X EBITDA. These are certainly reasonable multiples and sufficiently justified as a price target.

6. Reiterate Buy Rating

The beauty of Callaway Golf is that the shares will probably hit our price target whether the Company actually hits our EPS forecast or not. That is the nature of the seasonal trade. There are several ‘What ifs?’ that could lead to a share price well in excess of our price target. Such as, ‘What if the consumer recovery begins in 2009?’ or ‘What if the pent up demand actually leads to a bounce back year for golf equipment?’ or ‘What if Callaway Golf receives a takeover offer?’ or ‘What if Callaway Golf gets an offer to go private?’ We could go on, but you get the point.

On the numbers, Callaway is very cheap. Are there issues? There are always issues. But we are at the point on the calendar that we have to start to look past the issues and start to become constructive on building positions in Callaway, before the rest of the world gets excited about golf in the spring.

Our price target is being cut from $17.50 to $14.85, up 57% from the current price, but based upon the potential return we will reiterate our Buy rating.

Risks to Achieving Price Target

• Failure of new products to resonate with target customers
• Failure of golf equipment sales to stabilize domestically
• Severe deterioration of general economic conditions both domestically and internationally
• Failure to control costs and deliver expected margin improvements

ANALYST CERTIFICATION
I, Casey Alexander, certify that all the views expressed in this research report accurately reflect my personal views of the subject company (ies). I also certify that I have not and will not receive compensation with respect to the issuance of this report.