Callaway Golf: Reiterating Hold Rating on Reduced Estimated Total Sales

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

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1. EPS Numbers Follow Company Guidance

We are reducing our 2008 Full Year revenue and earnings estimates following the Callaway conference call of last week. Our revenue estimate slides to $1.136 billion, slightly below the guidance range given by the Company. Our assessment is that either sales or margins have to be affected by the consumer dislocation currently being suffered by the U.S. consumer. We also believe that significant promotional activity is likely to begin shortly to address the market share shortfalls currently being experienced at retail, particularly in the driver segment.

We also are shading the guidance on gross margin improvement, but only by 20 basis points. Again, we feel price at retail is the culprit here in the U.S. Therefore our EPS estimate is moving from $1.16 per share to $1.08 per share, which meets the bottom end of the guidance range suggested by management.

2. The Shape of Promotional Activity

How Callaway intends to boost sales in the face of difficult market share numbers is a subject of great debate. On the call, management suggested that demo days would cure a lot of ills. On that score we remain a little skeptical, as any customer that wanted to demo the FT-i or the FT-5 had a clear opportunity to demo them last year. Perhaps demo days can get the Hyper-X moving a little better, but we shall see. We find that demo days face the same “second year” issue with the X-20 irons as well.

So what shape is this promotional activity likely to take? Retailers want promotions that move more retail product off their own shelves, and hate anything else as they feel as though they are bearing the brunt of the equipment company’s difficulties. We are hearing about co-branding promotions that include merchandise credit cards that are offered with the sale of a particular club. Frankly, if it goes that way, we are supportive. Face it, Callaway remains a great brand, and one that many other high end brands would choose to be associated with. So if you can get a co-branding partners to share the cost of your promotional activity we are all for it, retailers be damned. Retailers’ problems are retailers’ problems. Our experience is that golf clubs will find a place to be sold, regardless of whether a retailer is there to carry them or not.

3. Still Decent Growth, So Why a Hold?

Producing 2008 EPS of $1.08 versus 2007’s EPS of $0.89 is still pretty impressive growth (21% year to year) in what can only be described as a lousy market domestically. So why have a hold rating? First of all, there is no doubt that as far as looking forward, there isn’t likely to be upside to that number, but there are many scenarios that could produce further downside risk to that number. That includes further market share erosion, or further erosion to the overall market in terms of consumer dollars spent. Also, no doubt the international numbers are impressive, but those are sell-in numbers also, from which there is very little that can be gained about sell-through until we are basically told how it is going.

Further pressure on domestic market shares could cause further price erosion and then we would be putting our pencils back to spreadsheets for another round of estimate cuts. We are not necessarily saying that is going to happen, but that is the risk. If the retail sell through numbers domestically continue to show problems, the price of the stock will find it difficult to advance meaningfully.

4. The Seasonal Trade has been Missed

We recognize how irritating it is to management that we continue to highlight the seasonal trade in shares of Callaway. In a perfect world, if you increase EPS, the price of the stock should go up. We frankly agree with the premise that management should cease giving guidance at all. It earns them nothing but headaches from people like ourselves. Who needs it?

But until all money on Wall Street is run by computers, there is likely to be a seasonal aspect to the price of Callaway’s shares that follows the seasonal pattern of golfers. Wall Street loves golf, and loves to buy Callaway when golf is coming into vogue. Why didn’t it happen this year? Because of economic dislocation and a bear market that is being blamed on a weakened consumer whose discretionary income is under attack. Have we often felt that the core golfer is immune to those types of pressures? Yes we have. At least for this year thus far, we have been proven wrong.

Therefore history would suggest that there will be an equal or better opportunity to put new money to work in Callaway sometime during the third or fourth quarter. If we sincerely believe that, then it is incumbent upon us to have a Hold rating, not a buy. Callaway Golf Co. (ELY)

5. The Good News About 2009

We are being told that any recession is likely to be a shallow one. If this is true, this could all work out to Callaway’s benefit in the long run. The way we see it, if you were ever going to go with several key products in the second year of sales and maybe miss the market a little bit, it would be in a year where the entire market is down anyway. You always want to have success, but if you are going to have difficulties, be lucky enough to have them at the right time.

In our view, a shallow recession or whatever we are going to describe this economic dislocation as, could lead to a tremendous 2009. After all, if the golf consumer has been shown to be vulnerable to the current economic situation, we have no doubt that the golf consumer is very early to recover. If overall sales are down meaningfully this year, it definitely suggests a certain degree of pent up demand for new clubs in 2009. This actually works to Callaway’s advantage, as 2009 will show significant new driver products and a key new set of irons to replace the X-20’s. Can you say X-30’s?

Therefore we see no reason to adjust our 2009 EPS estimate at this time. We will stay with $1.36 for 2009, up 25% versus our 2008 EPS estimate. If conditions as we see them remain the same we will be looking for an opportune time to bring new money back into the name. The timing depends upon how the rest of this year plays out.

6. Hold Means Hold

In the meantime, our Hold rating means just that. Hold. If we thought there was meaningful downside risk to the share price we would have lowered our rating further. As a Hold, we really have no current price target. We just think the shares are likely to track along with the general market, although if we get more difficult numbers at retail, the shares could struggle to keep pace with an up market.

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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.