Callaway Golf: Out of the Rough and Worth Taking a Swing At?

In my normal weekend activities of running through several screens, I noticed that Callaway (ELY) (7.50, $484mm) is one of the few companies in Consumer Discretionary that still trade below tangible book value (though it really doesn't - see below). I am not a golfer, and I have never looked that closely at this company until today. I intend to add it to my secondary watchlist and to try to get a better understanding of the "drivers". Kidding aside, while this one appears to be very cheap, it has gone nowhere for the past 15 years. Take a look at what hitting the wall looks like (click to enlarge):

The company has grown sales at an annualized rate of just 7% over the past 15 years, a time when golf has exploded. In the bottom panel, you can see that as sales stagnated, margins cratered progressively over time. In the panel below (click to enlarge), you can see that the stock bottomed well after the rest of the market:

In early June, the company slashed its dividend. Since 1997, it had paid a constant .28 per share annually, but, in order to conserve cash, it lowered the payout to just .04.

An even bigger sandtrap for investors was the $140m convertible preferred that was priced the following day. Facing a liquidity issue that had been clearly pressuring the stock, the company used the proceeds to pay off its entire short-term debt. This move must have been quite embarassing to management, as the company had been acquiring shares from the time current CEO Fellows arrived in 2005 (with no debt on the balance sheet) through 2007.

Fellows had served as CEO of Revlon (REV) in the late 90s, where clearly he learned about employing financial leverage. It looks like the stock took a month or so to digest this news, which was bad short-term (dilution) but clearly positive longer-term by eliminating the liquidity risk. Interestingly, its large shareholders added during Q2 (especially AXA and Fisher, its 2nd and 4th largest), though Allianz (AZ), previously its largest holder, puked out its entire stake. Now the stock looks to be recovering, as it has forged through the conversion price for that offering (7.05).

If one includes the preferred as converted shares (additional 19.9mm shares), the common stock is currently valued at about $633mm compared to equity of $697mm and tangible equity of $522mm. The chart below (click to enlarge), which is a bit off because it doesn't include the preferred shares, shows that this is as cheap as this stock has been in the past decade:

Cheap is nice, but it isn't sufficient. The company will report a loss this year, with the cost of the preferred equity (.09 per share) as well as weak business trends contributing. Analysts do forecast a strong recovery over the next two years, but these are the same guys who were predicting that the company would earn over $1 this year as recently as January.

The preferred stock can be called (and the dividend cost eliminated as it is converted to common) if the stock closes above 10.53 for 20 out of 30 days. One positive that I note is that the company has substantial exposure outside the U.S. (50%). The bulk of sales come from clubs, but even sales of balls have been hammered. The company cites pricing primarily and share loss as a secondary cause to this 20% YTD decline. According to the company, it has gained share in clubs.

For all the talk of innovation, I note that the company historically spent 5% and now spends 3% on R&D. The company has certainly moved to cut costs, even before sales turned down, so any sort of improvement in demand should really help EPS. Management doesn't have a lot of skin in the game, with CEO Fellows at just 1.2% and the entire team and the Board at under 3%. It is worth noting that the Chairman of the Board has purchased stock and excercised options in the past few months. Short-interest is quite high at almost 8mm shares, but it seems as if a portion of it is against the convertible preferred stock.

All in all, I find this to be cheap enough to merit watching a little more closely. I don't have a lot of confidence that this is the management team to make the company better - they are still in the box as far as I am concerned for placing the shareholders in harm's way by leveraging the balance sheet with short-term debt. I wish I had been paying attention to the story back when they diluted massively, but there is probably still some upside despite the 50% rally off the low.

Disclosure: No position

Comments

[Ricard:]

Interesting that something with margins as (seemingly) high as golf clubs can fare so poorly in a strong economic environment.

S&P STARS -

"Our risk assessment reflects ELY's well
established position in its industry, its absence of
long-term debt, and corporate governance
practices that we see as more favorable than
those of peers, offset by what we consider the
company's uneven revenue and earnings track
record and its heavy dependence on new
products."

Essentially, it had the wind at its back and still could not execute. Something stinks here...

I don't know much about this company either, but this seems like an archetypal "perfume stock" IMHO. The word "fickle" immediately comes to mind regarding stocks and products like this.

Sep 13 01:35 PM

[tin_man:]

Don't know where you're getting your information from that golf has "exploded" in the last 15 years. Participation rates have been stagnant (measured by the # of golfers, rounds played, golf ball sales, etc.). The only thing that has changed is that Tiger Woods has made golf more popular and increased TV ratings and revenues for the PGA Tour, but that has not translated into increased participation or spending on golf equipment.

Sep 14 12:03 PM

[Alan Brochs...:]

Thanks for sharing that view. My perceptions could be wrong - I am surprised, especially if one includes foreign markets. I have noticed younger and younger people taking up the sport too.


On Sep 14 12:03 PM tin_man wrote:

> Don't know where you're getting your information from that golf has
> "exploded" in the last 15 years. Participation rates have been stagnant
> (measured by the # of golfers, rounds played, golf ball sales, etc.).
> The only thing that has changed is that Tiger Woods has made golf
> more popular and increased TV ratings and revenues for the PGA Tour,
> but that has not translated into increased participation or spending
> on golf equipment.

Sep 14 08:55 PM