Dueling Fools
June 9, 1999

Callaway in the Rough
Bull Argument
by Warren Gump ([email protected])

Despite hitting the rough for the past two years as sales of golf equipment tightened, Callaway Golf is still the preeminent player in the industry with its Big Bertha products. Recognizing that his company had become complacent and drifted afar, Ely Callaway reassumed active management in October 1998 and has taken several measures to refocus the company. No longer involved in ancillary golf activities, Callaway is poised to return to successful and profitable growth as a golf club and ball maker.

A little over two years ago, Callaway Golf was in prime form, having become a market darling. Its golf clubs had taken the world by storm throughout the 1990s, leading to superb financial performance and wonderful stock price movements. From 1992 to 1997, the company's revenues jumped up from $132 million to $843 million. Earnings per share during the same period skyrocketed from $0.32 to $1.85. Each of these metrics improved steadily and consistently for five years as Callaway continued to roll out well-received new products.

Warning signs of trouble emerged in late 1997 as sales to Japan tumbled. In that year's third quarter, accounts receivable more than doubled although sales had only increased 32%. In mid-1998, the international sales slowdown was exacerbated by the United States Golfing Association's (USGA) announcement that it might prohibit the use of some metal woods, which are one of Callaway's more significant -- and profitable -- product lines. Even though the USGA ultimately declared that no products on the market would be affected by new rules, the damage was done. On an operating basis, the company earned only $0.14 per share in 1998.

To address the problems the company was facing, Callaway instituted a major restructuring plan late last year. The company consolidated back office operations and reduced its permanent work force by 24%. Other moves to reduce its cost structure included the discontinuation of expansion efforts into interactive golf sites, golf book publishing, and driving ranges. This enabled the company to focus on its primary business of golf clubs and balls.

Callaway's future at this point is dependent on two things. First, it needs to regain a strong financial footing in the golf club business. With the restructuring basically completed, the company was able to return to profitability in this year's first quarter. Sales rose 5% and net income increased 15% as the company started to turn things around. Even more importantly, inventories and accounts receivable are back in more normalized ranges. The Hawk Eye and Steelhead Metal Woods, Callaway's newest products, accounted for almost 60% of sales. Innovation, the hallmark of the Callaway Golf brand, still results in terrific results.

The second part of Callaway's resuscitation will be the introduction of the its own proprietary golf ball later this year. This endeavor, started in 1996, will lead to the introduction of a recurring sales source as golfers are repeatedly required to purchase balls. While some are skeptical of the success Callaway will achieve in the ball business, the company's strong brand name and history of technological innovations bodes well. Beyond providing another revenue source, the golf ball should improve profitability just by eliminating startup expenses the company has incurred. During the first three quarters of last year, Callaway expensed $15.3 million ($0.13 per share after-tax) on the golf ball company.

One reason Callaway has been able to successfully recover from its recent fall is its unleveraged balance sheets. While many hot growth companies load up on debt to fuel their growth, Callaway has been able to maintain a balance sheet free of long-term debt. For this reason, the company can use its cash flow to pay for intensified research and development and stronger marketing campaigns, rather than interest payments. Few people appreciate a strong balance sheet enough until a company hits a rough patch, at which point it becomes quite obvious why so many of the world's greatest companies maintain only modest debt levels.

Another tremendous asset for the firm is the honesty and integrity of Ely Callaway. While most chief executives put a polished spin on a year in their letter to shareholders, Ely tells it like it is: "1998 turned out to be the worst year in our history in some ways.... I am not proud of this, nor is anyone in the Company." Management credibility is important with any investment, but it is of paramount importance when considering a company that has run into problems. With the leadership of Mr. Callaway, there should be no concern about being misled.

When considering an investment in Callaway Golf, it is necessary to look at the big picture rather than the past two years. Look at the tremendous financial success the company has achieved since coming public in 1992. While the company has strayed, it is now back on track to do what it does best: make and sell top-quality golf products. With a great management team, strong balance sheet, a renewed focus on making the greatest clubs, and the imminent launch of the Callaway golf ball, this company is worth a putt into you portfolio.

Next: The Bear Argument