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Callaway Golf Company (NYSE:ELY)

Q2 2009 Earnings Call

July 29, 2009; 5:00 pm ET

Executives

George Fellows - President & Chief Executive Officer

Brad Holiday - Chief Financial Officer

Analysts

Dan Wewer - Raymond James

Rick Nelson - Stevens Inc

Scott Hamann - KeyBanc Capital Markets.

Tom Shaw - Stifel Nicolaus

Rommel Dionisio - Wedbush Morgan.

Todd Slater - Lazard Capital

Jeff Blaeser - Morgan Joseph & Company

Tim Conder - Wells Fargo

Kristine Koerber - JMP Securities

Operator

Good afternoon. My name is Marcello and I will be your conference operator today. At this time I would like to welcome everyone to the Callaway Golf second quarter earnings conference call (Operator Instructions).

I would now like to turn the call over to Brad Holiday, Chief Financial Officer for Callaway Golf. Mr. Holiday, you may begin your conference.

Brad Holiday

Thank you Marcello, and welcome everyone to Callaway Golf Company second quarter 2009 earnings conference call. Joining me today is George Fellows, President and CEO of Callaway Golf. During today’s conference call George will provide a few opening remarks, and I will provide an overview of the company’s results and we will then open the call for questions.

I would like to point out that any comments made about future performance, events or circumstances, including statements relating to estimated sales, gross margins, operating expense, preferred equity dilution, collectability of accounts receivable, estimated future inventory levels and the company’s estimated 2009 capital expenditures and depreciation and amortization expenses are forward-looking statements subject to Safe Harbor protection under the federal securities laws.

Such statements reflect our best judgment today based on current market trends and conditions. Actual results could differ materially from those projected in the forward-looking statements, as a result of certain risks and uncertainties applicable to the company and its business.

For details concerning these and other risks and uncertainties you should consult our earnings release issued today as well as the company’s current report on Form 8-K filed with SEC on June 8, 2009, together with the company’s other reports subsequently filled with the SEC from time-to-time.

In addition during the call in order to assist interested parties with period-over-period comparisons on a consistent and comparable basis we will provide certain pro forma information after the company’s performance, excluding charges associated with the company’s gross margin initiatives and on a currency neutral basis.

This pro forma information may include non-GAAP financial measures with within the means of Regulation G. A reconciliation of such non-GAAP financial measures to those most directly comparable financial measures prepared in accordance with GAAP will be provided on today’s call and additional reconciling information is provided in the earnings release we issued today. The earnings release is available on the Investor Relations section of the company website at www.callawaygolf.com.

I would like now to turn the call over to George, for a few opening remarks.

George Fellows

Thanks Brad, and thank you all for joining us. As you know during the first half of 2009 the Golf landscape continue to reflect the overall uncertainty of the worldwide economy and sustained its downward trajectory during the second, albeit at a somewhat reduced rate. This was not unexpected given the record pace achieved through this period a year ago.

While signs of recovery are evidence in a number of areas, the pace appears to be slower than originally hoped based on the most recent data and we feel call for somewhat more conservative projection for the balance of the year. The important takeaway however is that we are focused on the rate of recovery and stability rather than expectation of further uncertain declines.

The strategy we applied to navigate these difficult times targeted striking a balance between aggressive cost control to maintain liquidity with selective reinvestment and projects focused on strengthen the company’s long term market position to better take advantage of the recovery when it gets in to full swing.

Towards these end the company has exercised tight expense management, significantly reducing discretionary expenditures as well as executing major risks eliminated over 300 positions this year. At the same time selective investments have been made in several areas, including international market expansion, additional margin improvement initiatives the uPlay acquisition, and aggressive first move promotional activity to help kick off the golf retail season.

These investments are beginning to payoff and we believe will contribute to the company’s recovery as market conditions return to normal. The international business environment mirrors the U.S. in many respects, signs of stability or recovery particularly in Korea, Japan and Australia, continued strong performance in China and a stabilizing in much of Europe.

Further based on recent investments in infrastructure in Singapore and Malaysia, India and Latin America these markets are beginning to provide growth opportunities that will benefit the business in the mid to longer term.

The uPlay acquisition completed in December of 2008, is being very well received in the marketplace and demand is out stripping supply at this moment. This business will be profitable and accretive in 2009.

As an industry leader, we felt it important to take aggressive first move our action to stimulate the retail golf market in order to get the season kicked off given all the economic uncertainty. Clearly, this was not in expensive, but has achieved its object and benefited the Callaway market position in the U.S. and most international markets.

Year-to-date in the U.S., we’ve picked up 3.1 share points in drivers, 2.1 share points in irons, and 2 share points in putters with most international markets performing in a like fashion. These performance results bode well as we approach the end of the 2009 season and prepare for an anticipated better 2010.

Additionally, in order to secure liquidity for the balance of this economically uncertain period, we issued $144 million of convertible preferred equity. While this liquidity did not come without its costs and we are quite sensitive to its impact on our shareholders. It was the best alternative in a very tight credit market and one that we believe is, in the best interest of long term shareholder value creation, even while its short term affects are painful. Brad, will cover this key topic in more detail shortly.

Clearly, this year is disappointing to all of us; prior to the unprecedented economic downturn at the end of 2008 we’ve been on track toward achieving record results. As a result of this temporary set back, we are embarked on a close and thorough re-examination of every element of our business model with an eye towards reducing costs further and making all other necessary changes to adjust to new business realities that exist in this new economy.

All in an effort to get back on track toward achieving our long term financial goals of best in class performance in the consumer durable and apparel industry.

Now, I’d like to turn the call back over to Brad to give you more detail on the quarter’s results after which we’ll have some Q-and-A.

Brad Holiday

Thanks, George. To reiterate a bit on what George has already covered, overall market conditions remained soft during the second quarter resulting in a continued decline in industry-wide sales of golf equipment compared to 2008.

These conditions along with an aggressive pricing and promotional environment, unfavorable foreign currency exchange rates and reduction in retail inventory levels continued to have a negative impact on our business, with its financial results down compared to a record first half of 2008.

Despite these conditions we have been able to gain market share in almost all product categories, and have continued to invest in certain areas for long term growth. In reviewing their financial results for the quarter, we reported consolidated net sales of $302 million, a 17% decrease compared to last year sales of $366 million.

Net income for the quarter was $6.9 million compared to $37.1 million last year, and diluted earnings per share were $0.10 compared to $0.58 per share in the prior year. Excluding 2009, after-tax charges of $0.02 and 2008 after-tax charges of $0.05 associated with our gross margin improvement initiatives, our pro forma earnings per share for 2009, was $0.12 compared to $0.63 in 2008.

Through the first six months we achieved sales of $574 million, compared to record sales last year of $732 million, and diluted earnings per share of $0.21 compared to $1.19 last year. Excluding 2009 after tax charges of $0.03 and 2008 after tax charges of $0.06 for gross margin initiatives, our pro forma earnings per share for 2009 was $0.24 compared to $1.25 in 2008.

Taking a quick look at overall sales by product category, our wood sales for the quarter were $76 million, compared to $86 million in 2008. Year-to-date our wood sales have decreased 23% to $156 million compared to $203 million last year.

While out results have been impacted by industry wide decline if the woods category, along with the negative impact of foreign currency and conservative retail inventory levels, we have gained over three share points in the US in dollar share through the first six months, which is a reasonable proxy for most of our international markets.

Sales of irons and wedges for the quarter were $72 million, compared to second quarter sales last year of $100 million. Year-to-date sales in our iron category were $137 million compared to $197 million last year. Once again, despite the factors I just mentioned we have gained over two share points in the U.S. on a year-to-date basis.

Golf ball sales $58 million for the quarter compared to last year sales of $74 million. Year to date our total golf ball sales declined to $106 million compared to $133 million last year, due primarily to increased promotional activity and the fact that we had no new premium products this year compared to several competitive offering.

Our year-to-date U.S. market shares declined two share points. Putter sales for the quarter declined to $26 million versus $33 million last year, with year-to-date sales at $54 million compared to last year of $67 million. U.S. market share has increased by two share points through the first half of the year.

Accessory sales for the quarter decreased 5% to $69 million, compared to $73 million last year. Through the first six months accessory sales were $121 million, a decrease of 9% compared to 2008. The decline was partially offset by sales of new uPro GPS devices.

Turning to our regional breakout, U.S. sales declined 7% to $164 million for the quarter, compared to $176 million last year. International sales decreased 27%, to $138 million for the quarter compared to last year sales of $190 million. Foreign currency had a negative impact of $19 million on sales this quarter compared to last year. So in constant dollars international sales would have been $157 million, a decrease of 17%.

Through the first six months U.S. sales were $305 million, a 15% decrease compared to $360 million last year, international sales were $269 million, a decrease of 28% compared to last year sales of $372 million.

Foreign currency, once again had a negative impact of $42 million on sales for the first half of the year; so on constant dollars international sales decreased 16%. We have seen solid growth in Korea and China markets, and while Japans results have been significantly down through the first six months we are beginning to see some positive trends in July.

Gross margins were 36.3% for the quarter compared to 46.7% last year. This decrease in gross margin percentage is primarily due to the heavy levels of promotions during the quarter as well, as a shift by consumers to lower priced products.

Adjusted for gross margin initiatives, second quarter pro forma gross margins were 36.9% compared to 48% last year. Year-to-date gross margins were 39.4% compared to 47.3% in 2008. Adjusted for gross margin initiatives year-to-date pro forma gross margins were 40% compared to 48.1% last year.

Operating expenses for the quarter down 10% to $100 million, compared to $111 million last year. Year-to-date operating expenses were down 9% to $202 million compared to $221 million last year.

As George mentioned earlier, tight expense control this year in light of the economic conditions has more than offset incremental spending against uPlay acquisition regional expansion in Thailand and Malaysia and the expense associated with the April headcount reduction. As you know we recently completed the preferred equity offering that George mentioned.

On the first quarter call, we indicated that due to the unfavorable economic conditions, it was likely we would be in violation of the leverage ratio covenant under our credit facility at the end of the second quarter unless we took action. We engaged in discussions with our lenders and worked with our internal and outside financial and legal advisors to consider possible courses of action.

Ultimately, we concluded that a capital infusion from a preferred stock offering was the best alternative, and was in the best long term interest of our company and shareholders. The preferred stock offering was successful, which allowed us to remain in compliance with the governance of our credit facility and we finished the second quarter with no outstanding debt and $50 million in cash.

The offering also allows us to retain favorable pricing and other terms of the line of credit and provided us with the operational and financial flexibility to invest in and operate our business for long term growth in shareholder value.

Now moving to the balance sheet, consolidated net receivables were $263 million, compared to $287 million last year. Consolidated day sales outstanding increased to 79 days, compared to 71 days last year due to increase in customer incentive programs.

Collections on receivables remain good, as the overall quality of our outstanding balances. Net inventories were $228 million, a decrease of 3% compared to $236 million last year. Inventory, as a percent of trailing 12 month sales was 23.8%, compared to 20.6% in 2008 were down significantly from the 25.6% at the end of the first quarter.

Excluding the impact of apparel inventory, which is associated with the transition to Perry Ellis partnership, which was not in last year’s results and also adjusting for the negative FX impact on that sales, the adjusted trailing 12 month percent would have been 21.9% compared to 20.6% last year.

Given the significant sales decline this year, we are pleased with the responsiveness of the supply chain during this challenging time and feel we are still on track to achieve the low 20% range by year end.

Capital expenditures for the quarter were $9 million, and for the first six months were $19 million. We estimate 2009 CapEx to be approximately $40 million for the year. Depreciation and amortization was $20 million for the quarter; and for the first six months were $20 million, and our estimate for the full year remains at approximately $40 million.

As we noted in our pre-release last week, we estimate full year sales will be down 15% to 17% compared to 2008, due to what we believe will be continued softness in the retail sector. Gross margins will be in the range of 38% to 40% for the year, primarily because of continued promotional activity and price compression at retail through the balance of the year.

A portion of this continue promotional activity is because we believe that some of the smaller brands that have been more negatively impacted this year will be discounting heavily to move their inventory through the retail channels. The good news is that retailers have been ultraconservative this year, so the amount of inventory in the channel generally is at a lower than normal historical levels.

Operating expenses are estimated to be $370 million to $380 million, and as a net reduction reflecting not only the cuts that we have made this year in several areas, but also as I’ve already said includes investment spending against our uPlay acquisition, expansion into additional geographical markets as well as nearly $3 million in charges associated with the headcount reductions taken year.

I should also point out that the dilution from the equity offering is estimated at approximately $0.09 for the full year.

We would now like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Dan Wewer - Raymond James.

Dan Wewer - Raymond James

Two questions; George first, with the enterprise value of Callaway now at the lowest point in 10 years, are you or any members of the board concerned about the company possibly becoming an attractive unwanted acquisition for someone else?

George Fellows

It’s very hard to comment on hypotheticals like that. The fact is that we are taking all of the right steps in order to control our costs, so there is no easy money on the table for somebody coming over the transom, but again it’s very hard to predict anything like that and conjecture doesn’t help.

Dan Wewer - Raymond James

Second question, in terms of the market share of growth and with 2% to 3% in woods and irons, but in prior calls you noted that the industry might drop 15% to 20%, during 2009 and yet we are seeing revenues year-to-date, and irons off 30% and woods off 23% . So its trying that how do we square those significant declines in revenues year-over-year with this forecast of market share growth?

Brad Holiday

There are two fundamentals issues; one is consumer takeaway, which is the 15% to 20% that we were talking about and the second is a fairly large inventory adjust that most of the trade has been taking and will continue to take through the balance of the year.

So when you add those two up, you end up with a market drop if you look at it from the perspective of the manufacture far, far in excess of the 15% to 20%, you’re looking at reductions probably more in the neighborhood of 30% to 35%.

You add to that also, some of the numbers that we are talking about are obviously worldwide numbers, and there is a fairly significant FX affect on that as it relates to the international business and that complicates the calculation even further.

Operator

Your next question comes from Rick Nelson - Stevens Inc.

Rick Nelson - Stevens Inc.

I was kind of wondering if you could comment on inventory levels, both at Callaway and as you see them in the retail channel, and as corollary to that how you saw yourself in the promotional environment as we enter the third quarter, I didn’t recognize things were very promotional in 2Q. Are those promotions accelerating?

George Fellows

Let me address the inventory first. As Brad indicated, our inventories are really in quite good shape. Our supply chain responded very quickly to the downturn in the marketplace and in fact we still anticipate by the time the year is out that we will end up in the low 20s range as a percent of sales and substantially below last year’s levels. So our inventories are quite good.

The trade inventories are probably at this particular point time cleaner than they have been in quite sometime, largely because of the trade has been very conservative on their buy in and as have been very careful not to load.

Now it is anticipated however that the third quarter and probably the fourth quarter will remain quiet promotional, largely because there are many manufacturers who perhaps are necessarily and quite as good in inventory position as perhaps we are. There will undoubtedly be some dumping into the marketplace in the third and fourth quarter. That and of itself will obviously be very promotional.

So as we go out of the year, we are anticipating there will continue to be this level of pressure for the balance of the six months of the year.

Rick Nelson - Stevens Inc.

Can you also provide some insight into product introductions that you are planning for a second half, maybe as it relates to that second half of last year in terms of numbers or --

George Fellows

I’d rather not get in to any specifics in that regard for the obvious competitive reasons. As you are undoubtedly joined on this call by a number of people that are competing with us, but we will not have extraordinary introductory activity this year and in fact it will probably being somewhat less than, than it was last year.

I think our position is that we introduce policy at the end of the year solely to take advantage of the Holiday season and not necessarily to bolster any of the performance for the current year so. We are not interested in cannibalizing 2010 for the purposes of making this year look any better. So we will be at relatively normal levels as far as that’s concerned.

Operator

Your next question comes from Scott Hamann - KeyBanc Capital Markets.

Scott Hamann - KeyBanc Capital Markets

George, could you comment on the situation that, it seems like consumers are getting fairly conditioned to a discounted environment, I’m curious how this might impact some of your thinking and planning for 2010 in terms of kind of setting price points and determining which products you want to put some market weight behind?

George Fellows

I think it’s our judgment that 2010, from a promotional point of view not reach any renewal levels that we had this year, but that the consumers is still going to be focused more on the lower priced products, so the 299 driver price point will definitely still be the dominant price point next year as opposed to the 399 or 499 point. We have probably broadest golf line in the industry, so we cover all of the price points.

It’s really a matter of the way we believe the mix will go, because clearly even with the economy being in the current condition, there are people that are buying higher price point products and we clearly have some very good new introductions that will address those needs, but we also will have a full compliment of some very attractive new products at the lower price points.

We anticipate that from a mixed point of view, those will probably be the dominant part of the business going into next year.

Scott Hamann - KeyBanc Capital Markets

In our earlier prepared remarks, you made a comment about gross margin initiatives. Is there anything incremental that you would be prepared to talk about above the $20 million or $30 million you’ve talked about for the next two years, and then the $20 million or $30 million on top of that? What was the impact on gross margin of the initiatives for this quarter?

George Fellows

Let me address the first part of the question. We are continuing our pace with all of the gross margin initiatives that we’ve talked about before, the two that you mentioned. As I’ve mentioned in my comments earlier, because I think the economic realities are what they are and the marketplace is going to be different in ‘10 than perhaps it has been in the past. We are reexamining our entire business model and how we go to market.

We are looking for other opportunities to bring costs into line with this kind of new reality, but its still early days as far as that efforts concern. So I’m not really prepared to quote any specific number at this stage. Hopefully, in the subsequent quarters, when we get a lot closer to some of those things we’ll be able to give you color and insight into that.

Now, as far as the amount of the affect that the current gross margin initiatives have had on the current quarter, let me see. It was about $4 million for the quarter.

Brad Holiday

Just so you know, those are ongoing savings that we’ve had.

Scott Hamann - KeyBanc Capital Markets

Finally, on the operating expenses, you’ve done a good job kind of trimming the bell and keeping that pretty tight this year. How sustainable are these moving into next year? I know you’ve taken some pay cuts and 401(k) things. I’m just curious, are we going to see that balloon up next year or can we keep it pretty flat?

George Fellows

Well I think the effort as far as OpEx will be to maintain a very tight control on that. Some of the employee benefit areas will undoubtedly be put back in the budget as we go into ‘10, but we believe that we’ve identified other areas that will likely offset that.

So as far as the OpEx expectations for next year is concerned, we are quoting your number at this stage because, we’re really in the planning stage right now. I would fully expect OpEx to be under very, very tight control next year.

Operator

Your next question comes from Tom Shaw - Stifel Nicolaus.

Tom Shaw - Stifel Nicolaus

First question, kind of continuation of the trends that you talked about, are people really focusing on lower price points, potentially in next year. Is there anything from a technology perspective? Obviously, I think there is the rules change with the groups, but anything else that should entice somebody to buy a 2010 club rather than potentially paying a more of a promotional price for a 2009 or 2008 club?

George Fellows

Again, our company is known for very extensive innovation and technology. I fully expect that the product offering that we have in ‘10, given all the changes that will be a part of those offerings are going to be a strong enticement to somebody who’s a real golfer to go out there and try the new product.

The extent to which people are going to be attracted to the very low priced offerings even though they maybe older technologies is really hard to predict, but again golf being what it is and having golfers being who they are, I really believe given the importance of the sports to the individuals they are going to step up.

Now, will they step up in great numbers to $499 driver? Probably not to the degree that they have in the past I think that will be a smaller portion of the market place going forward, but will the normalize prices of 29 and there about be fundamentally the core of the golf market next, yes, I think so.

Again, depending on how heavily other people dump in to the market and to the extent at which they bastardize the pricing of the industry, that hard to predict, but our new products have always been very attractive and I think that we are going draw the appropriate attention of the real golfer who’s interested in real technology.

On top of that, you’ve got a remember that as our business trends more and more internationally the margins there are much higher than they are in the U.S., and I think that represents a, if not a total insulation but a offset to any tendencies if you go to the lower margin products in the U.S.

Overall I would fully expect the margins to be substantially improved over this year as we go in to 2010.

Tom Shaw - Stifel Nicolaus

Just remind us, the higher international margins is that a function of price point?

George Fellows

It is a function of price point, correct.

Tom Shaw - Stifel Nicolaus

Continuing on the international theme, you talked about some performance in China obviously, those can be some investments in India. Any updates I guess proudly speaking on the trends with golfers round played, spending per et cetera?

George Fellows

We are seeing some extraordinary things going on, hard the believe that I just went through a review yesterday of the South Pacific Group which is fund mentally Australian and New Zealand, their rounds played based on data that they showed increases of 20% to 30%.

I never heard of numbers like in terms of rounds played, so there is a resurgence of the business, the real issue from our point of view is not the level of interest in golf and whether not is in fact growing because I think that is certainly happening outside the U.S., pretty dramatically, but to extent to which the overall worldwide economy is going to prevent people from spending on equipment quite the to the same degree that they normally would.

We are seeing that come back, and as I indicated coming back in the U.S. bit more slowly than certainly we had hoped, but as the economy approves so will the tendency of golfers to go buy new equipment.

So, I think golf rounds are very sound and solid, they are even up almost two points in the United States, they are continuing to grow in some of the developing markets like China, and they are up substantially in places like Korea.

So, rounds played appear to be reasonably healthy. Our issue really is the tendency is likely to people going out and buying hardware, and that’s where are keeping a close eye on. That is very much tied to the economic recovery.

Operator

Your next question comes from Rommel Dionisio - Wedbush Morgan.

Rommel Dionisio - Wedbush Morgan.

When you guys referred to the general inventories being lower than normal, were you referring to just domestic or does include international as well.

George Fellows

No, that includes international as well.

Rommel Dionisio - Wedbush Morgan.

Second question, when you guys talked about peripheral brands, sort of from [money aggressively], are you guys seeing any brands actually lose shelf space going forward. Are they dumping the product because they are going to discontinue certain brands entirely?

George Fellows

That’s already been happening for good part of the year, and we believe it will continue to happen. As the trade takes a look at their largest working capital issue, which is inventory investment, they are cutting back on the [Inaudible] because those things don’t turn or develop a return for them. They can’t afford to put money there, so there has been a coming back of the overall selection, the number of SKUs and in many incenses the number of brands being carried.

Rommel Dionisio - Wedbush Morgan.

Do you expect that you might gain shelf space as a result of that next year.

George Fellows

Well I think by definition we probably will do that, because if you are a golf specialty, it’s not like you have other alternatives to put on the shelf. So, yes, the solid, larger, more proven brands will undoubtedly pick up shelf space for that, yes.

Operator

Your next question comes from Todd Slater - Lazard Capital.

Todd Slater - Lazard Capital

A couple of additional questions, wondering if you could give us some color on the decline in ball market share. What your strategy is to make money in this business? I think you expect to be profitable this year, but can the ball segment not just returned to be profitable, but also get to operating margins maybe in the high single-digit and low double-digit area. How long do you think that will, or what type of scale would you need to get there?

George Fellows

Let’s just talk about the current situation. Again, I don’t want to be looking at the market through rose colored glasses, but recognize that the past 12 to 18 months has really been quite extraordinary and very much out of character for the business.

There has been a fair amount of dumping of balls on the marketplace, one caused by, I’m trying to phrase this politely, but a particular player who had to make a transition to different balls from the one that they were marketing and they had a fairly extensive inventory of those.

So there is a fair amount of dumping, and lower prices associated with that. I think everybody is taking a good hard look at their inventory situation. I think there has been overreaction by some to what was going on and the dealing in the ball market has been a quite heavy incurrent and quite above normal. I don’t think that what we’re seeing today is going to be typical going forward.

So when you get by this stage and the ball market returns to a more normalized state, I think a lot of that promotional pressure on margins, if not goes away, certainly becomes less.

Now as far as our thing is concerned, again we did not have any new ball introduction this year. So we’re in the second year of our lead offering if you will. We will be offering some new balls coming up later on this year and into next year. That typically spurs the overall shipments and sale, and in this case we’ll also spread the margins.

So, yes I see as getting back to a more normalized state in terms of volumes and margins and then, and the on top of that we are moving some balls offshore, which has a very positive margin effect as well and the more that happens of course that contributes to the overall profitability of the ball business.

So we see a lot of things coming in ‘10 that should work in favor of making the profitability more attractive.

Todd Slater - Lazard Capital

So you do see return to a bull ball market, I’d just had to say that.

George Fellows

A bull ball market? You didn’t really say that. I almost don’t know how to respond to that.

Todd Slater - Lazard Capital

Don’t need to, let me get to my next question.

George Fellows

I see the ball market getting better yet.

Todd Slater - Lazard Capital

How do you think the new apparel relationship with Perry Ellis is going? How would you characterize that? How should we be thinking about that opportunity going forward?

George Fellows

I think it’s going quite well. As you know this year is still characterized by our selling off the ash works inventory, and in fact a lot of the styling for the early part of next year is still ash worth styling albeit PEI was able to get it into and tweak the designs and make them significantly better than they started out.

Certainly from that point of view it’s looking quite good. Our sales organization that we’ve established to sell the accessories and the apparel had their sales meeting, it was very, very positive that we already received. Again these were anecdotal stories, but early contacts with some accounts are quite positive as well.

So we think not only as the new relationship going to be significantly better than one we had before, but the business model that we operate under where we Callaway sell directly to the golf trade and are able to achieve a full margin of that sale is going to workout quite positively for us.

Todd Slater - Lazard Capital

What is the size of those relative markets, do you think the sporting goods market, let’s say versus the traditional market that Perry Ellis will be selling.

Brad Holiday

It’s hard to tell how big the traditional market is going to be because, it was never very successful getting in to that market in any significant way, Perry Ellis has a significantly greater capability in that regard.

So, it would be hard for me to give you a projection of how big that could be, but I can certainly gases it’s going to be bigger than it was. And as far as our part of the business is concerned, we also believe because of our single minded focus on selling the Callaway line into the golf trade, we’ll be able to do a much better job on both distribution as well as placement within the doors that we do have distribution.

So we think we can bring something positive to that part of the business as well. I’m afraid I can’t stare in to the crystal ball now and give you any projection other than. Our expectation is that it will be a stronger business now than it was before.

Todd Slater - Lazard Capital

Maybe if you could touch on the margin side of it then. Given that you’re marketing a big piece of that business, we combine the two pieces, do you think that’s higher operating margin business in your total or lower. That just has a positive impact influence on the overall operating margin at that gross.

George Fellows

Yes, it will. Just sort to put it in perspective for you, under Ashworth we had a licensing fee if you will. Now let me step back. The margin percentage will be different because licensing fee is 100% margin. The margin dollars that we are going to be getting are going to be substantially bigger.

Brad Holiday

And apparel, Todd is typically lower than our equipment sales, but from George is point of view from a dollar perspective we think that will be bigger year-over-year.

Todd Slater - Lazard Capital

Lastly just I am wondering but the guidance in terms of how we should look to model tax rate and the interest income going forward.

George Fellows

Well the fact that we don’t have outstanding debt right now, interest should be pretty low for the balance of the year, tax rate I already say let’s just stick with 38.5% that’s kind our standard rate right now.

The only thing that changes from that basically would be any types of resolution, any kind of audits or anything like that, but 38.5 is a good place we are at r right now Todd.

Todd Slater - Lazard Capital

Okay, any feeling about golf and getting in to the Olympics and that decision coming up, I guess in September.

Brad Holiday

It’s October actually. Again, there are seven sports voting for two positions, we feel good about the current standing of golf among those seven. Again, these are all anecdotal stories, but we hear back that we are certainly among the leading candidates, if not the leading candidate to get back in.

At this moment in time we are feeling pretty good about it. I think as we mentioned in some previous calls, all of our international folks are really poised to jump on it because we have been making contacts with all of the golf federations in the countries around the world so if the vote goes the way we hope it does we hope to be right out in front.

Todd Slater - Lazard Capital

If it goes through, what is the biggest changes that occur that you think will influence some of the trends?

George Fellows

I think clearly very clearly, on several different levels; first let’s talk about the governmental levels, countries like china, India, places like that who clearly view the Olympics as a showcase for their emergence if you will from third world status to something else, we will want to do something very special in that regard.

So all the programs, infrastructure building and investment in the sport, youth programs et cetera all start taking place once they realize that in seven years time they have to be ready with the ability to fill their respectable team.

From a governmental point of you began to see some action really across the board in many, many countries. By the way that will be true even in the countries that are developed as far as golf is concerned, but obviously more significantly in countries where that’s not the case.

At the other level, here again Olympic sports because of their prominence and attention, just attract more youth to get involved. Because the sport becomes much more high profile than it even is today and I would think that it would have over somewhat longer timeframe have beneficial affect on participation rates at all levels in many countries.

So I think we gain in terms of infrastructure building throughout the world, and I think we gain potentially in participation rates, both of which I think will be very, very beneficial for the business overall.

Operator

Your next question comes from Jeff Blaeser - Morgan Joseph & Company.

Jeff Blaeser - Morgan Joseph & Company

You mentioned earlier that you didn’t want to release any products in the fourth quarter, so as not to cannibalize 2010 sales. Did that happen in 2009?

George Fellows

We are in 2009.

Jeff Blaeser - Morgan Joseph & Company

Right and you released products late last year, did you see...?

George Fellows

Like I said, we fundamentally ship in products that we believe are going to take advantage of a holiday season. Now, sometimes we guess right and sometimes we guess wrong.

We have shipped in adequate amounts in some instances and in some instances we shipped in a little too much, but the clear intent is just to ship in the product that we feel is appropriate to take advantage of a holiday season.

In fact, there is a clear holiday season, if you look at consumption figures, there is a spike related to December and the consumption that relates to holiday and that’s, by the way not limited to the United States, it’s pretty much a factor in many international markets as well. So, yes that’s what our intention is.

Jeff Blaeser - Morgan Joseph & Company

Okay. On the domestic side obviously, on a relatively basing and sequentially it was much improved versus international even with that FX. Is that recessionary timing or is there more promotional environment domestically versus international, any color on that?

George Fellows

Yes, I think partly its recessionary timing. If you recall while we were sort of descending into this recessionary period in the United States, Japan was really selling along at a very, very good pace. As we started bottoming out, Japan fundamentally fell off a cliff.

Their entry into this unfortunate period was a lot steeper than most country. So, yes there is recessionary timing by contract. I think Europe entered into it a little later than the United States as well so.

There were clearly timing issues, but I would say that the promotional environment in the U.S. is much hotter than it is in most international markets and it’s fueled by whole variety of different sources, but we tend to be a bit more promotional here at times.

Jeff Blaeser - Morgan Joseph & Company

One final question, I’m sure you’re not going to discuss the illegal issue with Perry Ellis, but feel free if you like to. Have you seen impact from the patent change, what that’s had to do at the beginning of the year interims of tour ball or any market share gains there?

George Fellows

Again, their market is so unsettled at this particular point in time with whole ball is being discounted and new ball is being put in and other guys dumping on the marketplace. It would be very difficult to draw any conclusion about that, but it will also settle out probably next year and we’ll have a better handle on it then.

Operator

Your next question comes from Tim Conder - Wells Fargo.

Tim Conder - Wells Fargo

Couple of items as usual here, could you quantify the EPS impact of FX Brad in the quarter and then year-to-date? Then I guess along the similar lines, if you could quantify collectively, obviously not by product line unless you want to, but collective impact of promotions. What you anticipate either in the quarter, year-to-date or for the year?

Brad Holiday

Well, Tim it’s really hard to take FX as we’ve talked about. It’s easy to give you the sales impact of translation, but there’s an awful lot of movement that goes on below the line.

I mean, we’ve roughly said in the past, it’s about 70% flow through in terms of the impacts so you can take sales and take your normal margin if you will, but that’s a really a tough one, we can give it to you pretty clearly on the revenue side. So, it’s really tough to give to it you in terms of bottom line. What was the other question I’m sorry on the what?

Tim Conder - Wells Fargo

Earlier in the year on the FX side though you guys, I think quantified that you anticipate on the year-over-year basis, FX having…?

Brad Holiday

Frankly, we’re going to move away from that, because there are just so many moving parts when you get down below sales, it really is a very, very difficult thing because it has to do with timing of inventory moving in and et cetera. So it’s just a very difficult thing to do.

So revenue is about the best we’re going to be able to do going forward. As a rule of thumb, as we’ve said in the past it’s roughly 60% to 70% on average, but it’s really hard to go quarter by quarter because of timing. What was the second question, Tim I’m sorry.

Tim Conder - Wells Fargo

Similar type of thing, Brad on the promotional impact that you seen on gross margins and again just sort of trying to get a sense for the year. So what type of rebound, I guess again that’s the root of the FX question also, that if everything held constant and the promotional environment went more normalized, what type of rebound obviously that’s a type of context we are asking.

Brad Holiday

For the quarter Tim, just to give you an idea. If you look at the drop in gross margins, the pricing mix which would include the shift of consumers to lower price points as well as the promotional activity represented about a seven percentage point decline.

Just to put it in context, okay. FX was a majority of the [raft] as you kind of took a look at the quarterly numbers. So that’s a rough shot, but the sales, the price and sales mix that everything, that’s promotional plus people to shifting to lower price points.

As George mentioned people have shifted down to that 299 and lower because of the promotional activity, so it’s a little bit of compo and hard to pull it apart.

Tim Conder - Wells Fargo

50/50 be a good beginning stab at it.

Brad Holiday

Whatever you want to use, it’s so hard to pull it apart.

Tim Conder - Wells Fargo

On the gross margin initiatives again you are still getting, Brad you said $4 million benefit in the quarter on a year-over-year basis. What point I guess good companies always try to find incremental savings opportunities ongoing basis, but at what point do you slide in to the bucket to where this is sort the normal course of business rather than saying we’re going to take a charge for this, this is a specific initiative.

Brad Holiday

I would tell that is we embarked on the GMI it was over a two year period and so we kind of bucket it because we have it in last year’s numbers we kind of eliminate kind of the expenses against that. I think the George’s point as we look over the next four years we’re looking at a broader kinds of initiative that should get us another roughly $40 million to $60 million.

That’s more of a bigger change in foot print and kind of the whole manufacturing distribution et cetera. It’s a bigger initiative and as we go forward and talk about the future and the things we are looking at, we’ll give a little bit more color with regards to kind of this broader strategy if you will, but the first two years was really kind of those GMI that we always talked about, but as we shift to go forward there will be additional costs as we under take some of these new initiatives.

Tim Conder - Wells Fargo

Then from a inventory perspective, Brad or George whoever wants to answer this. Its sounds like retailers George, you referenced several times retailers were excessively cautious, at the beginning of the year, that should have been continued to be cautious and then maybe especially being cautious with some of the lesser brands out there, so you are gaining share.

Where are we, do you think at a point to where you are going to get the one-to-one sell-through, you getting back sell-through, shipment at the ratio, that comeback sometime maybe late first quarter, second quarter is the best you can tell?

George Fellows

I think it’s going to be with the new season Tim, because we are pretty soon going to enter in to the tail end of season if you will when normally all of the trade tries to run inventory down to lower level as possible.

Certainly all the green grass guys that are going to shut down try to do that and the golf specialty that largely in non-golfing areas do the same thing. So we are not going to get the one-in-one out stage now.

As we enter into the new season next year and the new season in the Sunbelt, I think we’ll see more of the one-in-one out kind of a situation.

I fully expect that there will be some inventory load for the beginning of the season, not a typical of what happens in the marketplace under normal circumstances, I think that inventory load will be smaller. I think that will affect the quarterly breaks that we see in the business in ‘10.

My guess that it would a lot less front loaded and distributed a bit more evenly than historically has been the case, but its little early to tell that. If you want to know when we are going to get into the one in one out stage, the second quarter is probably an approximation of went that will happen.

Brad Holiday

And I think along that line, Tim I think that the manufacturers that have a really good supply chain and respond quickly to those orders will be the ones that will probably benefit, because of kind of a new, what I’d call marketplace out there.

Tim Conder - Wells Fargo

Along that line, roughly two years ago you gentlemen were talking about showing what you were doing there in Carlsbad and talking about taking sort of a replication and putting it Europe or maybe one in Asia long term you could respond quicker. Where do we stand on that whole process?

George Fellows

We are right in the middle of sort of very broad review of what the manufacturing footprints for this business will have to be. The model shifts a little bit on the one hand, a lot of the automation that have gives us flexibility to in a modular fashion create manufacturing sites elsewhere. There are certain efficiencies however, in low cost labor markets that offset that advantage.

So we are really still working that proposition. We clearly feel that there is a labor costs we can take out of this. We clearly feel that the distribution costs associated with the business are also subject to some further reduction and I think perhaps later of this year, very early next year we’ll be able to give you a very much clearer picture of how we’re coming out, because ultimately what we want is the lowest cost manufacturing footprint and process that we can ultimately develop and we’re getting pretty close to it.

Tim Conder - Wells Fargo

Lastly, again you talked earlier about some of the ball production continuing to shift a little bit more offshore. At this point, what do you see that as a percentage of your ball sales this year, what’s produced offshore and what will that be next year?

George Fellows

Not going to give you the specifics there for obvious reasons. I can just tell you that, it will be a much higher percentage offshore next year than it was this year or any year prior and where the appropriate balance will ultimately fall, because there will always be a reason to have some onshore production and exactly what that level is going to be I think, depends on a number of other things that we’re doing, but you can be assured that the offshore manufacturing a ball is a going to be a much higher percentage going into ‘10.

Operator

(Operator Instruction) Your next question comes from Kristine Koerber - JMP Securities.

Kristine Koerber - JMP Securities

Just a quick question, can you just give us a little more color on the international trends throughout the quarter on a monthly basis? You said that you started to see a positive signs during the month of July in Japan. How were trends throughout the quarter?

George Fellows

Depends on the region, as Japan is showing significant life coming into July or the end of the quarter and they are now feeling pretty good about the rest of the year. Australia, I think has looked pretty good for a good portion of the quarter. Korea has looked pretty good for a good portion of the quarter.

In the case of Europe, Scandinavia is pretty strong, U.K. is having some difficulties, Eastern Europe is doing well, but we’re a little watching carefully the economic situation there. So it’s really very hard to generalize for you, because it’s really as quite different as you go from region to region.

Operator

Ladies and gentlemen, we have reached the end of the allotted times for question and answers. Mr. Fellows, do you have any closing remarks you’d like to make?

George Fellows

Yes, just to reiterate, I understand everybody is discomfort with what’s going on in the marketplace and I obviously share it. The only thing I can reassure you about is that we’ll continue to run the business trying to strike an appropriate balance between running a tight ship as far as expenses are concerned, to continue to look throughout the organization and the way we do business to take cost out of the process, but at the same time we are going to continue to make appropriate investments in areas that we believe position the company properly to take advantage of the recovery when it takes place.

We believe that we’re perhaps at the earlier stages of the recovery. I know in the short term, that doesn’t give you the most attractive earnings picture, but I can assure you that we believe very strongly in the long term it is a much better strategy to follow as far as creating shareholder value and its one that we will continue to follow going forward.

So hang with us, we think that things will improve, I just hope they improve faster than it looks right now, but we are very conscious of the marketplace and want to make sure that we are ready for it when it impact does improve. Thank you all for your attention and we will be happy to talk to you again next quarter.

Operator

Ladies and gentlemen that does conclude today’s conference call. We would like to thank you for your participation, you may now disconnect.

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Source: Callaway Golf Company Q2 2009 Earnings Call Transcript
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