It's important for long-term investors to develop a guide for doing their investment research. Over the years I have developed questions to guide me in my thinking when researching the publicly traded universe. These questions represent a good starting point before doing more in depth research. Let's look at Callaway Golf (NYSE: ELY).
1.) What does the company do?
When you buy shares in a company you effectively become part owner of that company. Therefore, it's important for an investor to understand what a company sells. Essentially, Callaway Golf distributes high quality golf equipment and accessories.
2.) What do the fundamentals look like?
Investors should also look for companies that grow revenue and free cash flow over the long-term, retaining some of that cash for reinvestment back into the business and for economic hard times. Excellent revenue and free cash flow growth serve as catalysts for superior long-term gains.
Golf has suffered from a declining participation rate over the past decade. Over 800 golf courses have closed during that time. This pressured Callaway Golf's fundamentals as a result. Over the past five years Callaway Golf saw its revenue decline 16% (see chart below). Cost cutting efforts and an emphasis on higher margin items contributed to a turnaround in Callaway Golf's bottom line. In 2014, Callaway Golf registered net income for the first time since 2008, clocking in at $16 million. The company also saw its first free cash flow reading since 2009, coming in at $26 million.
However, Callaway Golf has struggled some in FY 2015 with its overall year-to-date revenue down 6%, when factoring out currency fluctuations due to "softer than expected market conditions" in the international market and a delayed product launch. This gives indication that the demand headwinds continue. Callaway Golf's year-to-date net income declined 17% year-over-year, and its free cash flow deficit expanded 3%.
Callaway Golf's balance sheet is actually ok. The company possessed $27 million cash, which equated to 8% of its stockholder's equity. I prefer to see companies with cash amounting to 20% or more of stockholder's equity, and this company needs all the help it can get.
I don't like debt. It creates profit and cash flow choking interest cost. I like to see companies with long-term debt amounting to 50% or less of stockholder's equity. In the most recent quarter, Callaway Golf's long-term debt came in at 32% of stockholder's equity. So far this year, its operating income exceeded interest expense by 13 times. The rule of thumb for safety lies at five times or more. It should be noted, however, its operating income only exceeded its interest expense by a scary 3.2 times in FY 2014.
Callaway Golf does pay a dividend. I like to see companies pay out less than 50% of their full year free cash flow, retaining the rest for other uses. Last year, Callaway Golf paid out a prudent 12% of its free cash flow in dividends. Currently, the company pays its shareholders $0.04 per share per year translating into a yield of 0.5%.
Over the past five years, Callaway Golf's subpar fundamentals translated into a total return of 35% for its shareholders vs. 104.4% for the S&P 500 as a whole (see chart below).
3.) How much management-employee ownership is there?
Investors should always look for businesses where the managers and/or employees own a lot of stock in the company. Managers with a great deal of stock in the company will take better care to maximize company profits, which will enhance share price and their personal wealth along with the wealth of shareholders. According to Callaway Golf's latest proxy, no member of its executive ranks owns more than 1% of the company's stock. This simply means the incentive of a huge ownership in the company isn't there.
4.) How does its "Report of Independent Registered Public Accounting Firm" stack up?
Every year a company employs external auditors to audit financial statements and evaluate whether it maintains adequate financial controls. At the conclusion of the audit, you want to see a letter from auditors with the language "unqualified" or "fairly presents", which generally means that the financial statements and internal systems in constructing them were clean or adequate. If you see "qualified" or "adverse" in the auditing letter's language then deeper issues in a company's financial statements may exist. Last year, Callaway's auditors said the company maintained adequate internal controls and gave its financial statements an unqualified opinion.
5.) What types of risk does it have?
It's always important for investors to weigh the various risks such as exposure to political risk in parts of the world where war is the norm, competitive positioning, and market price risk. Callaway Golf does operate globally, which means it's exposed to political risk as evidenced by the adverse currency translations it experienced so far in FY 2015.
The company also operates in a business considered a luxury, which means the company essentially competes, not only with other sporting goods companies, but with the consumers' more pressing personal financial needs, such as food and clothing.
Callaway Golf trades at 110 times suppressed earnings vs. 19 for the S&P 500 as a whole, according to Morningstar, meaning that this company comes with a high amount of market price risk in addition to the fundamental risks highlighted above.
6.) What does its forward analysis look like?
It's possible that its cost cutting strategy and focus on higher margin products could yield some positive results for Callaway Golf and its investors. However, I am going to stay away from the company as an investor given the luxury element of the industry, the decline of golfing in general and the corresponding decline in fundamentals.