Why are We Waiting to Invest in Callaway Golf?

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Introduction to Callaway Golf

Callaway Golf is a global sporting company that designs, manufactures, markets and sells golf equipment, gears, apparel and accessories. Since its public market debut in 1992, Callaway Golf has evolved from a golf club manufacturer to a leading distributor and manufacturer of premium golf equipment and accessories.

Callaway golf stock key financial data
Callaway Golf key financial data. Prices are correct as of 28 July 2020. Source: Company report.
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    In recent years, Callaway Golf has undertook a new strategic direction in an effort to diversify and grow its business. Here’s a breakdown of its acquisitions since 2017

    • Jan 2017: Acquisition of OGIO International, a leading manufacturer and distributor of premium storage gear for sports.
    • Aug 2017: Acquisition of TravisMatthew, a leading designer and distributor of premium golf and lifestyle apparel, gear and accessories.
    • Jan 2019: Acquisition of Jack Wolfskin, a premium outdoor apparel, footwear and equipment brand

    With its recent acquisitions, the company is focused on integration and realizing cost and revenue synergies. The aim is to create a diversified global business platform while investing strategically in areas complementary to golf.

    Callaway golf segmental revenue split
    Callaway Golf segmental revenue split. Source: Company reports.

    The golf market at a glance

    According to National Golf Foundation, golf is an $84 billion industry and remains the no.1 outdoor pay-for-play individual participation sports in the US.

    Despite this, the golf club markets are highly competitive and are served by a number of well-established and well-financed companies with recognized brand names. These include TaylorMade, Ping, Acushnet (Titleist brand), Puma (Cobra brand), SRI Sports Limited (Cleveland and Srixon brands), Mizuno, Bridgestone, and Parsons Xtreme Golf (PXG).

    Similarly, the golf ball segment is equally competitive with Acushnet (Titleist and Pinnacle brand) commanding ~50% market share globally.

    All in all, while not the market leader, Callaway Golf remains a top 3 market share leader in most categories. The company continues to be regarded as a leader in technology and innovation in its field.

    How does Callaway Golf make money?

    Callaway Golf makes money through selling golf equipment (clubs and balls), gears, apparels and accessories. Its main expenses are cost of raw materials, R&D and distribution & marketing.

    Geographically, Callaway Golf generates 46% of its revenue from the US, 25% from Europe, 14% from Japan and 14% from the rest of the world. Arguably, the regional exposure has been fairly stable over the years.

    Callaway golf regional revenue split
    Callaway Golf segmental revenue split. Source: Company reports.

    Understanding Callaway Golf

    Robust financial position

    Callaway Golf is in good financial health. A low and declining debtor/sales ratio highlights the company’s efficiency in collecting revenue. Its creditor/cost of sales is also fairly robust at 7% in 2019. While a higher ratio is more favorable to the company, we argue that this gives them room to delay payments to suppliers if required, although there is no reason to suggest why they would need to. Inventory/sales ratio also remain stable over the past decade, with an average of 26%.

    Callaway golf financial ratio
    Callaway Golf’s key financial ratios from 2009-19. Source: Company reports.

    Last but not least, robust free cash flow conversion. Since its growth plans in 2015/16, FCF conversion continues to creep up, which is always a good sign.

    Topgolf's stake

    One of the reasons we like the stock is because of the optionality of its stake in Topgolf. Callaway Golf currently owns 14% of Topgolf.

    While the pandemic has deflated its valuation, we guesstimate the stake to be worth somewhere between $360-390 million. The proceeds can be used to further diversify its earnings, corporate purposes or to pursue further growth inorganically.

    Guests playing Topgolf in Naperville IL
    Topgolf in Naperville IL.

    Did you know?

    Topgolf is a global sports entertainment company offering fun and unique ways to experience golf. There are currently 50+ locations across the US, the UK and Australia.

    Slow but steady growth and margin expansion story

    After years of underperformance, the management team has successfully executed a turnaround to reinvigorate the Callaway Golf brand. The pivot to a growth strategy in a consolidating industry is welcoming. Consequently, we’re confident that the Group will emerge as a winner.

    First, the brand refresh of Callaway Golf’s franchise over the years has begun to pay off. This is evident through its increased market share, accompanied with both volume (partly driven by acquisitions) and margin expansion.

    Callaway golf segmental product margins
    Callaway Golf product margin by segment and revenue growth rate 2013-19. Source: Company report.

    Secondly, its diversification through acquisitions. The company has completed four acquisitions since 2016, pivoting themselves into the higher margin premium active lifestyle segment.

    Despite the acquisitions, our forecast indicates that the bulk of its synergies have not come through completely and should expect further cost savings post integration. We hypothesize a lower cost of equity (lower perceived risk) in the medium term given its diversification, benefiting its valuation.

    Callaway golf segmental revenue split
    Callaway Golf segmental revenue split. Source: Company reports.

    Finally, Callaway Golf’s commitment to innovation and growth remains the key driver for the company. It has consistently plough back profit into R&D, amounting to ~$390 million from 2009-2019. From balls and putters to wedges and drivers, the results were higher quality products manufactured with cutting-edge technologies. The Big Bertha driver is an excellent example. Accordingly, this is also why it experienced margin expansion despite a highly competitive market.

    Significant insider ownership

    As a rule of thumb, for company of this size, we would expect at least 1.5% of insider ownership.

    The latest proxy filing described an insider ownership of ~2.2%, with the CEO owning just under 1.4%. With limited insider selling since despite stock options vesting, we have reasons to believe that the management’s incentives are aligned with shareholders’.

    Key risk to Callaway Golf stock

    The elephant in the room is clearly the Covid-19 crisis. While wholesale sales of clubs were up over 30% year-on-year in June, we remain very cautious on its growth outlook in the coming months, especially with the second-wave of coronavirus taking center stage.

    Second, its FX and hedging risk. The company derives >50% of its sales outside the US, which means that its revenue is at the mercy of the US Dollar. The company does, however, employ a hedging strategy to partially neutralize the impact of FX to a certain extent. In general, a weaker US Dollar is favorable to the Group.

    Lastly, the lack of operational synergies could be a key risk. As for all acquisitions, there is always uncertainty in realizing synergies. While we see this as a low risk scenario, the impact of expanding coronavirus has certainly made it more challenging to do so.

    Callaway Golf financials

    Here’s a snapshot of Callaway Golf financials.

    Callaway golf income statement revenue build
    Callaway Golf’s income statement and revenue build. Source: Company reports.

    Callaway Golf valuation

    We consider the three key groups: golf equipment, athletic and leisure as Callaway Golf’s comparables. In computing our “Synthetic” valuation, we assume 60% golf, 25% athletic and 10% leisure, using the 2019 revenue split as a reference. In summary, we find the Callaway Golf’s valuation reasonable relative to its peers. A lower profitability, but accompanied with a lower valuation. However, the lack of dividends and continuous low profitability vs peers introduce some form of uncertainty for long term investors like us.

    Callaway golf valuation and comparables
    Valuation comparables for Callaway Golf. Where possible we use normalized metrics in our valuation. * synethetic valuation represents 65% of Golf, 25% Athlectic and 10% Leisure, based on Callaway Golf's 2019 revenu split. Prices correct as of 28 July 2020. Source: Bloomberg & company reports.

    Why are we waiting to invest in Callaway Golf?

    Callaway Golf has a sound business plan to grow the business in the medium term. Led by an experienced management team with significant stock ownership, the Group is now focus on investing strategically in areas complementary to golf, with the focus of establishing synergies and realizing efficiencies across the all brands.

    A fantastic franchise and a leader in advanced golf technology, we believe these will continue to propel the business forward. In addition, the optionality in Topgolf creates a unique proposition not only for the Group but also potential investors.

    Now, the big question is whether we would be adding to our portfolio today. We’re in a bit of dilemma, since we like the prospect of the business, but are cautious on its valuation. Here’s why.

    First, we think the lack of dividend is an issue for long term investors like us. It pays a regular quarterly dividend of $0.01 per share, which is arguably non-existent. Furthermore, we know from our previous article that statistically non-dividend payers tend to underperform its peers.

    Moreover, the Group has not paid a meaningful dividend for more than a decade. With its current acquisition strategy, we can really bid goodbye to proper dividend for the foreseeable future.

    Secondly, somewhat underwhelming profitability. While we acknowledge it is cheaper vs its synthetic valuation, we believe that the profitability can be further improved. We would be looking for further evidence that its acquisitions can bring about improved profitability and cost efficiencies.

    In short, we like the stock, but not the price. All else being equal, we would be interested to add the stock should it trade around $16, which is 15% below where it trades currently. In the world of golf stocks, we shall follow the quote of World Golf Hall of Famer Gary Player.

    “A good golfer has the determination to win and the patience to wait for the breaks.” – Gary Player

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