Description

Adams Golf (ADGO.BB) is a manufacturer of golf clubs trading at 4.2x EV/EBITDA, has no debt, has $14M in cash on the balance sheet and has a market cap of only $34.7M. A number of successful club introductions over the past two years has enabled ADGO to take share (though their total share is small) and to put the company back in the black. Should the company continue to introduce clubs that gain market acceptance, then EBITDA, earnings and cash reserves should continue to grow as should the multiple it receives.

Adams Golf IPO'ed in 1998 on the strength of its Tight Lies fairway woods. The Tight Lies club offered an inverted trapezoid design that lowered the center of gravity on the clubhead to below the equator of the golf ball which makes the ball easier to hit properly. (Note: Though I have spoken with two golf equipment retailers about their opinions on Adams' products, I myself have never swung a club.) Unfortunately, Adams failed to follow up with clubs that were a hit on par with Tight Lies and then they suffered along with all club makers as rounds played and industry-wide equipment sales declined during the recession and bear market.

It was not until Fall of 2002 that Adams came up with a new club that sold well, their Idea hybrid irons, the first hybrids on the market. Hybrid irons combine elements of both woods and irons and are designed to make the ball easier to hit and get up in the air. They followed with the Ovation fairway woods, an updated version of Tight Lies; then the Red Line driver, the first legal 460cc driver; and now the Red Line RPM.

Since 2002 each new introduction or update of an existing line has sold well enough to drive a net increase in sales as sales of new products made up for and exceeded declining sales of older models. The company prides itself on their commitment to research and generating new ideas that make golfing easier for the average player. The commitment appears to be paying off as this year Adams sales rose ahead of the industry. Still, the truth is that any new idea they bring to market is quickly copied by the much larger competition. (Adams has 2-3% total share, but more on certain types of clubs.)

The CFO, with whom I have spoken on and off for about a year, was more tight-lipped about upcoming product introductions than he has been in the past so I am unable to map out their plans for the coming year. However, any new introduction or extension bears the risk of failing just as does an apparel maker's fall line of clothes. In fact, I would flag this as the biggest risk with the stock.

In 2003, Adams had $50.8M in revenue, up 34% from depressed levels in 2002. Re-leveraging pushed a 1600 bp increase in gross margins, generated $4.1M in EBITDA, $2M in net income and $0.08 in untaxed earnings. Earnings are mostly untaxed and will be for years to come due to $18M in NOLs. The NOLs will also help the company continue to grow its cash levels. Through Q3 2004, revenue is up another 12% and for the full year, I expect a similar increase. FY 2004 gross margins should rise another ~300bps, EBITDA should be at least $5M and they should produce $0.10 to $0.11 in untaxed earnings. My EBITDA calculations add in amortization of deferred compensation. Capex is minimal; $308K in '03, $267K through Q3 in '04.

Management feels so burned by their post-IPO experience that they do not even issue earnings press releases. The CFO says they may start doing so next year and could potentially hire an IR firm and maybe peruse relisting. These actions could help create interest in the stock.

I have asked what they plan to do with all the cash. They admit they could use it for increased marketing or for buybacks or for both, but they have no plans yet.

In terms of marketing, they increased their budget 10% this year, but one advertising area the company has foregone is sponsoring pros on the PGA tour: too expensive. Instead they have focused on the Champions Tour where costs are less and the players are more likely to carry more woods, the club which is the company's original claim to fame. They are toying with the idea of sponsoring some lower ranked PGA players in hopes of riding them to the top if they make it big. It's a strategy that has worked for some other smaller equipment makers.

In terms of buybacks, I get the feeling that right now they like coming to work knowing that all that money is there keeping them from ruin should things go wrong again. However, maybe another round of successful product introductions could get them feeling stable enough to put the money to work in a more shareholder friendly fashion than just sitting in the bank. An aggressive shareholder could be a catalyst here.

The downside of failed product introductions is clear: the stock price goes south. The upside over the next 12 months should they follow on with good or great selling products and combine that with even a basic investor relations program (and maybe a buyback plan) could be significant as the higher multiple would be on future EBITDA which should be higher. Right now a 7x multiple on trailing EBITDA of $5M yields a $1.90 or 40% above current levels.

However, given the competitive factors in the industry, I believe the attraction at the moment lies in the fact that the business is profitable, has prospects, has a low absolute valuation and has a margin of safety enhanced by the cash on the balance sheet.

Catalyst

Continued success with product introductions.
Initiating an effort to tell the story to investors.
Potential for buybacks.