Dueling Fools
June 9, 1999

Callaway in the Rough
Bear Argument
by Paul Larson ([email protected])

Recently I heard an interesting phrase that I think applies to Callaway Golf in 1999. The phrase goes something like, "Once the bloom is off the rose, all you're left with is a thorny bush." After looking at the recent financial results, I think there can be no doubt that the bloom has certainly left Callaway.

1998 was, to put it kindly, a train wreck for the company. For the first time since coming public in 1992, the company showed declining sales in a fairly dramatic fashion. Not just a flattish year, revenue was down over 17% while the company's Cost of Goods Sold actually rose. That crunching sound you hear is the company's margins. As one might guess, the bottom line was a distinctive color of red last year, and the stock got absolutely clubbed.

While I'm not going to harp too much more about the recent past, many of the factors that led to Callaway's decline are still in place. Namely, the company's "Big Bertha" line just isn't as popular as it once was. A truly innovative club when it first came out earlier this decade, the latest trends in golf are moving away from the monstrously sized drivers.

Bigger may have been better a few years ago, but now there are other technical innovations that are sweeping the club industry, such as moving weight to the outside of the head and having a harder impact surface. The Big Berthas sold themselves when they first came out, but now the cycle is coming back around. Just as Callaway came out of nowhere to grab a huge chunk of the club market in the early '90s, some other competitors, such as Orlimar, are now making serious waves in the sport.

Beyond increased competition, there are signs that perhaps the whole club fad may be waning. I've got to wonder how many golfers are going to sink another couple of hundred bucks into the latest model driver only to find that their hook or slice is still there. Each year may bring some minor innovation in the equipment, but not the type of quantum leaps that will have golfers opening their wallets. Clubs just aren't a repeat purchase item except to the absolute elite in the sport. Besides, it's the golfer that determines the score, not the club.

The shifts in taste and in the market have not only had a drastic impact on the financial results, but they have also stirred up the company. Callaway's president was ousted last year, and 700 other employees also lost their jobs. In addition, Ely Callaway, the company's founder, was brought back from retirement. There's no doubt that Ely is a skilled and successful businessman, but turning around a troubled company is no easy task, and Ely at his advanced age may not have the energy or the motivation to take the needed measures to lead the company back into profitability.

One of the strategies that many Callaway bulls are counting on is the company's move into golf balls. I've really got to question if there are any more technological innovations that can be applied to the dimpled golf ball. Can Callaway have the same early success in balls that it had with Big Bertha? I'd say the odds are fairly long on that bet.

Callaway also faces one of the classic problems that many in the high end of the sports equipment industry face. That is, how do you maintain a brand's exclusive reputation while selling into the mainstream market where most of the money is? Sell too much and the exclusivity is out the window. Sell too little and they don't make the growth that investors demand. It's a balancing act that Callaway has yet to master.

Beyond that, Callaway suffered a serious loss of confidence on Wall Street after last year's ruinous results, and investors are not likely to push the company up to premium valuations again any time soon. Mulligans don't come easy in the market. Plus, like I said earlier, the bloom is off the rose.

Even if golfers' tastes do go back towards the huge clubs, Callaway's competitors are now much more attuned to what golfers want and are matching features as best they can at generally lower prices. More importantly, Callaway's technological edge just isn't as sharp as it once was, and the company does not appear to have any sort of sustainable advantage going forward. At this point, Callaway may just another bush in the forest of competitors that is the golf equipment industry.

Even though I'm writing the bearish argument and teeing off at Callaway here, I'll admit that there may be some value in the company's shares. There is no debt on the balance sheet and the company's brand does have some value. I also wouldn't be surprised if the stock bounced slightly higher six months from now. Nevertheless, Callaway lacks any sort of sustainable advantage that would give shareholders the type of long-term compound returns that make investing in stocks truly rewarding. There are certainly many better stocks out there to take a swing at buying.

Next: The Bull Responds