Callaway Golf Is Cheap Enough - If The Strategy Is On Point

Summary

• ELY shares have stumbled after a long bull run, capped off by a 9%+ decline after the acquisition of German apparel manufacturer Jack Wolfskin.
• The deal moves the company heavily into the outdoor apparel space - and limits the importance of the legacy golf business.
• Given the company's success in golf, the move seems to add risk - and to suggest that management sees the industry on the whole as tapped out.
• But if management is right, there's a nice path toward years of above-market performance for ELY.

As it turns out, the only thing that could stop Callaway Golf (ELY) stock was Callaway itself. A successful turnaround in the golf business in the first half of the decade was followed by impressive market share gains in the last two years. Callaway raised guidance after each of the first three quarters in 2017 - then did the same in 2018. ELY shares soared as a result, nearly tripling between early 2016 lows and 2018 highs.

While the stock did sell off a bit after Q3 results in late October, a weak broad market likely didn't help. But the declines accelerated in November, capped off by a 9.4% decline after the company announced its acquisition of German outdoor apparel company Jack Wolfskin for $476 million.

The drop to a six-month low leaves ELY in an interesting position. Valuation pro forma for the acquisition still looks reasonably stretched. Performance over the past few years seemingly has disproven the concerns I've called out regarding the golf business. But Callaway still has the largest share in what likely is a flattish market (maybe at best), and the acquisition itself might suggest ELY management sees its growth in golf at least decelerating. And with the deal, ELY shares now rely almost as much on what essentially is an outdoor lifestyle roll-up as they do on the golf business:

source: Callaway presentation on Jack Wolfskin acquisition

That said, there is a clear path for the acquisition - if it works - to drive sustained growth in the consolidated business, and upside for ELY shares. For that to happen, the Callaway management team has to be right. If it is, ELY will be a multi-year winner again.

Red Flags in the Acquisition

There is no shortage of reasons to dislike the Wolfskin acquisition. From a broad standpoint, the deal appears a classic case of "fixing it until it's broke". The last two softgoods deals - bag maker OGIO and apparel brand Travis Mathew - looked like smart, bolt-on deals that proved accretive relatively quickly and nicely complemented the core golf business.

That business, meanwhile, has performed exceedingly well over the last several years. Market share gains led to growth in 2015 and 2016 despite soft end markets. Callaway then posted a sizzling 2017, with organic revenue growth of almost 9% and a 100%+ increase in adjusted operating income on a consolidated basis (and a sharp rise even on an organic basis). The launch of Epic woods was a major factor: per the 10-K, volume rose 7%+ but pricing jumped 32.9%. Results so far this year look equally strong, and across the board, with club revenue rising 18% and golf balls sales up 21.6%, as Callaway continues to take share in the latter high-margin market.

The Q3 presentation did detail some market share losses over the year, surprisingly, but the underlying business still supported a stock that hit, and stayed near, a 19-year high. Admittedly, profit-wise, golf still drives roughly two-thirds of pro forma EBITDA (based on disclosed acquisition multiples) - but this now does feel like a potentially different story, with the Wolfskin deal pretty much completely outside the golf space.

There's also the question of what the acquisition means relative to Callaway management's projections for growth in the golf industry. Raymond James analyst Dan Wewer asked directly on the post-acquisition conference call if the deal meant "the original golf industry itself just doesn't offer enough incremental growth". Callaway CEO Chip Brewer somewhat dodged the question, saying that the last two acquisitions had been successful, and adding, "It is fair to say this is outside of golf, but I don't believe it's outside our core and outside of businesses that we have proven ourselves to be successful."

Perhaps. But there's a big jump between ~$200 million combined in bolt-on acquisitions at least adjacent to golf - and a nearly $500 million deal that levers Callaway up (guided net leverage ratio after closing is nearly 3x) and is virtually unconnected to the golf industry. And it's fair to ask why Callaway is spending 11.8x 2018 EBITDA (and a higher multiple to FY19 guidance) to buy Wolfskin when it could have done roughly the same deal to buy...Callaway Golf.

That's a bit glib, to be sure. ELY's EBITDA multiples were higher earlier this year, and a significant recapitalization likely would require a tender offer at an even higher price. Still, Callaway hasn't repurchased much in the way of its own stock on the way up: less than $25 million between an August 2014 authorization and the end of 2017, and $200,000 since a new $50 million program was put in place in May. Callaway has had opportunities to bet on itself and bet on golf: it's chosen instead to go in a different direction.

As far as the target goes, meanwhile, risks abound. Wolfskin originally was purchased by Blackstone (BX) in 2011 for what Brewer said was €800 million, and reports at the time said was €700 million. It's possible both are true, given Euro devaluation over that stretch. But whichever number is correct, Blackstone paid something close to US$1 billion, at least: more than double what sellers are willing to take now (in a much stronger economy and equity market).

The debt underpinning the deal was restructured last year: the company has been run by its lenders since then. Revenue growth appears to have stalled out, though management highlighted currency effects (Wolfskin's US presence is minimal; Europe and China are the two key markets) and refused to give more color on past trends before the deal had closed. And EBITDA of ~$40 million this year appears below past peaks - and is expected to decline next year as the company restarts investments behind the business paused by the capital structure constraints of the past few years.

Fundamentally, it sounds as if Callaway is buying a turnaround play - and paying ~14x 2019 EBITDA for the privilege. The sell-off following the deal shaved about $175 million off ELY's market cap - which in turns suggests the market thinks the company should have paid ~$300 million, or ~9x 2019 EBITDA. Obviously, it's not quite that simple - but that math makes rough sense. At the least, it's clear investors are not real happy about the deal, and there are good reasons why.

The Case for ELY

That said, ELY is at a six-month low on the news - and that lower pricing incorporates at least some of the acquisition-related risk the company is taking on. And those investors who have bet on Brewer so far have been well-rewarded for doing so.

Qualitatively, there is a reasonably strong case for the deal. Callaway is diversifying away from golf - but into an industry that very well might have stronger overall growth rates going forward. For Callaway's golf business itself, after two strong years driven by driver and iron launches, comparisons were going to get tougher - and growth was likely to decelerate.

Meanwhile, the Wolfskin deal does fit rather nicely from a geographic standpoint:

source: Callaway presentation on Jack Wolfskin acquisition

Callaway's existing infrastructure can expand the brand into the U.S., Japan and Korea. Wolfskin's North America revenue, for instance, is "almost insignificant" per the call. There are synergies on the cost side as well, with management highlighting potential savings in back office work and the value of Wolfskin's "state of the art" distribution center in Hamburg, Germany.

Callaway management is forecasting an eventual acceleration in growth to $50 million in EBITDA and 'mid-single-digit' revenue growth once it gets to work with the business. Given Brewer's work with the legacy operations, and the company's steady ability of late to underpromise and overdeliver, some investors might be willing to give Callaway the benefit of the doubt on the deal.

And if Callaway is right, this can work - and work out well. Pro forma Adjusted EBITDA for 2018 is $193 million - but even that seems low. It includes guidance for the legacy business of $153 million this year, which implies a $19 million decline year-over-year in the fourth quarter (a loss of $34 million against $15 million in Q4 2017). Even given guidance for lower gross margin, that seems exceptionally conservative.

From that level, Callaway is targeting $200 million-plus in EBITDA in the "near- to medium-term", per the presentation. And at that level, ELY could have some upside - and maybe a path toward continued outperformance.

Valuation

The 2.9x leverage ratio suggests pro forma debt of about $560 million - and net debt closer to $500 million. Combined with a fully diluted market cap of $1.7 billion, that $200 million target still implies an EV/EBITDA of 11x. That's not necessarily cheap: Acushnet (GOLF) is at ~9.5x based on its 2018 guidance. ELY likely deserves a premium based on recent results - but that premium only holds if the Wolfskin deal turns out to be a winner.

But from a multi-year standpoint, there is a nice path to double-digit annual returns for ELY. $50 million from Wolfskin plus growth in the legacy business from $153 million this year (or ~$155-$160 million, assuming yet another guidance beat) gets that EV/EBITDA multiple under 10x. Callaway is going to look to deleverage, amplifying gains in the equity. And if the diversification strategy is successful, the EV/EBITDA multiple can re-rate higher. If 40% of EBITDA (or close) is coming from higher-margin OGIO, Travis Mathew, and Jack Wolfskin, models need to start blending in comparisons to competitors like Columbia Sportswear (COLM) and North Face owner VF (VFC), both of which generally trade in the mid- to high-teens on an EV/EBITDA basis.

Look out a few years, and Wolfskin EBITDA of $50 million plus $200 million from the legacy business (7% increases annually over 4 years) gets EBITDA to $250 million. A 12x multiple gets EV to $3 billion. Even zero debt paydown gets ELY to $26 or so, and deleveraging can add a dollar or two to that price. Modeling EPS is somewhat inexact, given still-limited commentary on D&A and tax rates, but that $250 million figure seems to suggest something like $1.50 in EPS ($30 million D&A, with $10M incremental; $25 million interest; 21% tax rate), and a high-teen P/E similarly suggests something in the range of $26.

That $26 figure suggests 10%+ annual returns - and there's obvious upside optionality from higher growth in the golf business, as 7% growth represents a sharp deceleration from recent performance. Assume Wolfskin disappoints, and stays stuck at 2019 guidance of $33 million. A lower 11x multiple (actually a discount to the valuation for much of this year) still gets the stock to $22 or so. That's disappointing, to be sure: in that scenario, appreciation is about 5%+ a year for four years. But it does highlight the fact that disappointing results from Wolfskin don't necessarily sink the case for ELY - or suggest a short case relying on the acquisition itself. The declines into and out of the deal have priced in at least some likelihood that the acquisition, like all too many, falls short of initial expectations.

Both the numbers and the trading highlight the story here: ELY remains a bet on management. Brewer and his team have led an impressive turnaround, huge market share gains, and solid appreciation in the stock. (Even after the recent declines, ELY has risen 170% since Brewer took over in March 2012.) Investors rightly could see that history as good reason to keep that bet going. It'd be a surprise - though not impossible - to see ELY gain another 170% over the next six and a half years. But a double over a multi-year period requires the Wolfskin deal to be the winner management expects, and probably low-double-digit annual EBITDA growth from the rest of the business.

That's certainly doable. But it requires the move here to be the right one - and at least some help from the golf industry (and in turn, the macro environment) over that period. I'm not quite confident on either front to turn bullish just yet. Investors who are, however, need to at least take a long look at ELY on the dip.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.