Callaway Golf's Strong Growth to Continue

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

In the last few weeks Callaway Golf reported their full year 2007 results and then held their 2008 Analyst Day.

1. 2007 Full Year Results

Callaway finished 2007 with earnings per share of $0.89 per share. When we look back our initial forecast following the 2007 Analyst Day was for EPS of $0.69 per share. Callaway beat our initial estimate by a wide margin. Also, when we look back we can see that our initial 2008 EPS estimate was $0.98 per share. Callaway is currently guiding 2008 estimates into a range of $1.08-$1.18 per share. Yet due to market conditions, the price of the stock is little changed in that time.

2. Raising our 2008 EPS estimate

After reviewing the Callaway guidance for 2008, we are raising our 2008 EPS estimate from $1.12 per share to $1.16 per share. Estimated earnings of $1.16 per share represent a 30% year to year growth rate of earnings per share. Callaway has some leverage against the earnings forecast, in that their guidance pre- supposes minimal shares repurchases, even though Callaway has an open $100 million share repurchase authorization, having already repurchased approximately $167 million worth of stock over the last two years. So obviously they can use the share repurchase to help drive earnings per share to their guided figure, or possibly beyond.

The simple arithmetic computations argue strongly in favor of share repurchases (after tax earnings yield versus after tax return on cash balances, cost of paying the dividend versus return on after tax return on cash, after tax earnings yield versus after tax cost of debt). Obviously these computations do not take into account working capital needs, but the economic justification for share repurchases is compelling, which supports management’s guidance for 2008 earnings per share. If we were to use the forward EPS figures for these calculations the rationale for share repurchases becomes even more lopsided.

3. Initiating 2009 EPS Estimate

Following the pace of Callaway’s guidance we are initiating a 2009 EPS estimate of $1.39 per share. We are actually using an operating margin that is below management’s guidance. Assuming all our estimates are correct (which as we have seen from 2007 is hardly likely to be the case) this estimate offers year-to-year EPS growth of approximately 20% for 2009.

4. Growth Drivers

What is driving this impressive EPS growth? It’s hardly the revenue line, as 2008 revenue growth is estimated at approximately 2.25% and 2009 revenue growth is estimated at approximately 4%. There are two primary drivers of the bottom line as far as we can tell.

Leverage from international sales improves Callaway’s bottom line profitability. In 2007, 47% of sales came from international sources, which generated 53% of profits. Management believes that over the next several years international sales can grow to as much as 60% of total revenues, which would be more reflective of the total global golf mix. This factor is more important in the longer term demographic, but it is clearly affecting the bottom line today.

The larger current impact on the bottom line is the management team driving significant efficiencies into the business which is having a tremendous impact on both gross and operating margins. As impressive as the margin gains are, we think the overall golf industry in underestimating what is happening at Callaway fundamentally over the long term.

5. Factory of the Future

Callaway is evolving their operations into the golf factory of the future. This is going to make Callaway a very difficult competitor to deal with over the long term. Callaway is slowly but surely automating the process of golf club assembly. Very few golf club equipment manufacturers have either the financial power or the will to undertake this process.

Each step that Callaway takes down the path of automation and robotic assembly not only removes the human component as a factor of cost, but removes the potential for repetitive stress injuries, decreases the workers compensation cost (not insignificant in places like California), and has the added benefit of improving the quality and the consistency of the product.

So over the long term, Callaway is going to be able to produce golf club equipment cheaper than the competition, and at the same time better from a quality standpoint. This is a powerful one-two punch.

A good example of how powerful the process can be, let’s look at the golf ball business which has always been highly automated. With strong market shares and high capacity utilizations, Acushnet (a division of Fortune Brands, manufacturer of Titleist and Pinnacle golf balls) has been able to produce a very high operating corporate contribution for Fortune brands. Their dominance in golf balls has become almost a self-fulfilling prophecy, and their leverage in the golf ball business is impressive.

Since Callaway operates at high volumes in the golf club business, they have the opportunity, and most importantly the financial wherewithal, to create the same type of high operating corporate contribution as a result of efficient operating capabilities.

6. Maintaining Price Target of $22 Per Share

Given our increased 2008 EPS estimate and our initial 2009 EPS estimate we would be well within our rights to increase our price target from $22 per share. We choose to be conservative, and $22 per share is 18.9X our 2008 EPS estimate, a significant discount to the 30% estimated EPS growth rate. This also represents a discount to our 2009 EPS growth rate of 20% as well.

Risks to Achieving the Price Target Include but are not limited to the following:

- Poor weather in key demographic regions.
- Reduction in rounds played leading to decreased sales.
- Failure to anticipate changing product trends in golf consumer preferences.
- Inability to maintain improved gross margin initiatives.
- Irrational competitive market resulting in lower average selling prices.
- Poor general stock market conditions leading to P/E multiple compression.

Disclosure: The analyst manages a hedge fund that owns shares of this company.