Callaway Golf: Negative Forex Reduces 2009 EPS Estimate

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

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1. Callaway Reports Year End Results, Reducing 2009 EPS Estimate

Callaway reported their year end results last week which were in line with their earlier pre-announcement. The wake-up call on the conference call was the disclosure of the potential impact of foreign exchange rates on 2009 results. It was disclosed that at the current level of global spot currency rates that Callaway would take a $56 million hit to the revenue line with a much larger proportional hit to the bottom line due to the fact that their cost of sales are all $US denominated.

This results in a sharply lower EPS estimate for 2009. We are reducing our 2009 EPS estimate from $0.92 per share to $0.50 per share. This is a larger reduction than suggested by Callaway, but certain important exchange rates have continued to work against them since the end of the year, and the sales volume is very front end loaded on the calendar. We are trying to get our earnings estimate to a worst case scenario.

2. Impressions from the PGA Show

While we will be publishing our PGA Merchandise Show report at a later time, we should include some of our Callaway specific impressions. First of all, Callaway recognizes that they have not done enough to capture share in the $299 driver category. They also recognize that the consumer still wants technological innovation, but that the consumer wants it coupled with a value proposition. Therefore capturing share in the $299 driver category is going to be extremely important.

Callaway is clearly increasing the marketing emphasis on this category for 2009 with the introduction of the Callaway Diablo driver. They are even making an effort to get usage of the driver on the PGA Tour. Rocco Mediate plans to put the Diablo driver in play on tour, and possibly Stuart Appleby. This is almost unprecedented, as almost all tour spend has focused on top of the line products. It’s truly a new day, but we agree with the direction.

The Diablo also incorporates a unique pseudo-geometrical shape, thus impressing upon the potential customer that a significant amount of technology is inherent in this design.

3. UPlay Acquisition

If the UPlay acquisition had been for a material amount, we would certainly be concerned about it’s potential for success or failure. After all, no company we know of has ever made a penny selling hand-held GPS technology to golfers. The subscription model just has not worked. With UPlay, the model is going to be a single purchase price, then a $10 fee per course to download the relevant information. We remain skeptical.

It was suggested to us that the technology could be adapted to the creation of other non-golf products. While we don’t expect to see Callaway competing with Garmin or Tom Tom any time soon, we are curious to see what some of these other products may be. But we have the CEO on record; “Trust me, we will make money with GPS”. To that we say “Trust us, we will keep on asking”.

4. Compression to Tangible Book Value

The shares are now selling at a minimal premium to tangible book value, and a pretty significant discount to stated book value. Our judgment continues to be that while price targets are irrelevant at the moment, downside risk is significantly limited. With the forex headwind currently impacting EPS, we can only say with great assurance that the forex relationships are going to change again, sometimes for the better, sometimes for the worse. Frankly, as it relates to changes in foreign currencies, there is no ‘normalized earnings’ per se. Thus assigning benefit to forex gains or deducting points for forex losses is a waste of time.

Callaway is running their business about as well as can be expected in this environment. Most industry participants were impressed with their Q4 top line results. We think, with a global footprint and significant financial resources that ELY will ride this out better than most. We also believe that analysts trying to micromanage the rating on ELY will be very late to the party when the turn comes. So we will stay here, reiterate our buy rating, and see just what the spring has in store for us. It’s risky, but risk is our business. No price target is necessary from these levels.

5. Initiating 2010 EPS Estimate

We can make a case why consumer confidence should actually start to pick up in 2009, but we can’t make a case why it should pick up fast enough to help a calendar front-loaded industry such as the golf industry in time to help much in 2009.

The self fulfilling prophecy of industry participants forecasting weak sales is enough to keep open-to-buys low and inventory stocking modest. If thing pick up in 2009, the chase will be on, but who can get there?

We think 2010 could be quite different though. We judge that any recovery of consumer sentiment will be felt in the 8-9 million core golf consumers first and more vigorously. Every participant we talked to agreed with the concept of demand building as consumers defer purchases, and the more they defer, the greater the pent up demand will build.

Thus when sentiment turns up, business is likely to have an explosive ramp off the bottom initially, resulting in a very strong first year recovery. Therefore, our estimate reflects what that recovery could look like if indeed we come off the bottom in 2010 or before. Our initial estimate for 2010 is at $1.24 per share. Our revenue estimate is for revenues to recover to $1.125 billion. While our confidence in our 2010 estimate is not high, our confidence that our 2009 estimate is likely too low is pretty strong.

Since this is a single point estimate based as much off an economic call we are not going to attempt to base any price target off of this estimate. Still, we want it out there and on the record.

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Risks

• 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

Disclosure: 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.