Description

An investment in ELY at current levels represents a very attractive risk/reward opportunity. Because of company history there is significant cost and market share opportunity from new leadership committed to reengineering corporate costs, manufacturing, marketing, and supply chain. Moreover, ELY is the only independent golf company of scale with the best brand in the industry, debt free, has long-term growth opportunity, past private equity offers as support to the valuation (currently trading about 20% below those offers) and is a significant free cash flow generator (even during years with poor management and product). Based on a 17x multiple to earnings potential upside is over 80% from current levels.

BACKGROUND
Callaway Golf Company is world’s largest manufacturer of golf clubs and golf balls. The company manufacturers and sells its products under the Callaway Golf, Odyssey, Ben Hogan, and Top-Flite brands.

Under the leadership of Ely Callaway, Callaway Golf established itself as the world’s leading golf club manufacturer and the leading brand in the golf industry. However, following Ely’s death in 2002, the company struggled to maintain its market leadership. Ely’s handpicked successor, Ron Drapeau, only lasted two years and from August 2004 to August 2005, the company was run by an interim CEO (board member, Bill Baker). Essentially, Callaway had ineffectual leadership for 3 years in the face of:
• Difficult macro factors, including a post-9/11 decline in vacation travel in 2002, record rainfall in 2003, and major hurricanes in the Southeast and Caribbean in 2004. These have been key contributors to year-over-year single digit declines in rounds played over the last several years
• TaylorMade aggressive discounting and marketing to grab #1 share in the high margin wood segment as well as Nike’s entry into the club and ball markets
• Callaway manufacturing and product missteps (i.e., decision to design a club beyond United States Golf Association restrictions and therefore unable to be endorsed by Pros. Also, poor inventory and supplier management)
• Top-Flite acquisition (September 2003) and subsequent integration missteps (i.e., kept two manufacturing facilities, lack of leadership and focus on cost synergies)

The following is a quick timeline of recent events:
• January 2005 – Hired a search firm to help find new CEO
• May 2005 – Reportedly received a $16 all cash offer from Thomas H. Lee and William P. Foley (insurance exec)
• June 2005 –Hired Lazard for advice on a possible of sale of the company and other options. Reportedly approached by Bain Capital and MacGregor Golf with a $16.25 offer for the company
• July 2005 – Rumors that Nike could be interested in ELY (not unreasonable and fits into Nike’s strategy of buying ancillary businesses as it has with Cole Haan, Converse, Starter, and Bauer. Other strategic buyers might include AdidasReebok or Fortune Brands)
• August 2005 – named George Fellows (62 years old) as CEO and president. Former president and CEO of Revlon from 1997 to 1999. Lead independent director elected as new Chairman. Also announced that company is not for sale, with Fellows mandate to fix operating issues, re-establish brand, and grow the business. Key terms of Fellows employment agreement include:
o 850K annual salary with bonus opportunity at 100% upside. 160,000 restricted stock to vest December 31, 2008. In addition, 400,000 options which are exercisable as follows: 133,000 on 8/1/2006, 133,000 on 8/1/2007, and 133,000 on 8/1/2008 (all set at $14.93) – Fellows subsequently purchased 10,000 shares in the open market at 16.40 and there have been other insider buys as well
o Accelerated vesting based on change of control
o Term through 2008 and temporary living paid for through July 31, 2006
o November 2005 – Announced plan to buy back as much as $50 million of common and pay an annual dividend of .28 cents per share (currently ~2% yield)
• February 2006 – Analyst day introducing Fellows and outlined long-term targets
• April 2006 – Pre-announced revenues and earnings below analyst expectations. In particular, announced preliminary Q1 sales of 300 million (flat vs. 2005) and EPS of .32 - .34 (significant margin improvement over 2005), but about 20% below analyst forecasts on revenue and 30% on EPS. Management attributed it to the later launch of new products as compared to last year.

THESIS
An investment in ELY at current levels represents a very attractive risk/reward opportunity. Because of company history there is significant cost and market share opportunity from new leadership committed to reengineering corporate costs, manufacturing, marketing, and supply chain. Moreover, ELY is the only independent golf company of scale with the best brand in the industry, debt free, has long-term growth opportunity, past private equity offers as support to the valuation (currently trading about 20% below those offers) and is a significant free cash flow generator (even during years with poor management and product):

• Compelling Valuation. ELY has the opportunity to significantly improve earnings and free cash flow – over the next 2.5 years earnings power is $1.25 per share on flat revenues and $1.60 per share based on stated long-term management goals. [Note that historical peak earnings were $1.85 per share achieved in 1997 on a 20% smaller revenue base, but albeit in a less competitive and faster growing market.] Additionally, the company should generate about $3 in FCF over that time period and be at full year 2008 FCF of approximately $1.50 per share. Using a 17x multiple on the midpoint of earnings power, upside could be to $24 before FCF build and $27 after. Downside is protected by the current valuation, the industry leading brand, and the likelihood of a private equity take-out or a strategic acquisition if a turnaround does not take hold. Based on these factors, it is difficult to see ELY trading more than 20% off of the latest private equity offer of $16.25 or downside to $13.00 over a sustained period of time. Moreover, upside does not consider more reasonable leverage and share buybacks or non-core real estate sales (estimated at ~$1 per share pre-tax) which could drive 100% price appreciation in 2.5 years.

Looked at another, on a flat revenue base, ELY should be able to realize $70 million of cost savings and 80 million in gross margin expansion (on approximately $1 billion in sales). The $70 million in fixed cost saving attributable to company guidance and the $80 million in gross margin expansion based on a reversion to margins 15+% below historic peak margins (from 42% to high 40% gross margin move vs. peak margins in the mid 50’s, a level that seems unreasonable given input costs, increased competition, and ball business in the mix). As a result, ebitda potential on flat revenue is $221 million (implied 18.5% ebit margin) and assuming that management only gets 75% of the way there equates to $166 million (implied 13% ebit margin) at a 9.5x multiple (discount to Fortune Brands) would yield a $23.50 stock (including $3 in FCF build).

• Only independent golf company of scale with best brand in the industry, debt free, and despite recent problems brand equity is not significantly damaged. Despite its recent challenges, ELY is an established high-end brand with potential for growth, the only independent golf company of scale, and debt free. It has #1 or #2 market share in each of the major golf product categories (drivers, irons, putters, balls) and has several of the most recognized trademarks in the golf industry – Big Bertha Drivers, Odyssey putters, Top-Flite balls, and Ben Hogan clubs and balls.

Moreover, even over the last 4 difficult years with bad product and poor management the company generated $261 million or $3.40 in aggregate FCF – equivalent to about 25% of the current market capitalization. Based on channel checks, it appears that ELY’s relationships with customers are undamaged and the company is still known as a leading brand with the best technology innovation and best trade relationships. Fellows said that he believes ELY has the strongest retail relationships of any consumer products company he has ever worked with. For these reasons, ELY would make an extremely attractive private equity or strategic acquisition.

• New management team that has already identified significant areas for improvement. ELY appears to be a classic example of a company that was managed tightly by a successful entrepreneur for its entire history, put no thoughtful succession plan in place, and was not able to properly recover from the founder’s death. Moreover, because of the strength of the Callaway brand and Ely’s personality, the company’s processes, production, marketing, and product development did not significantly evolve over time. Industry contacts characterize ELY as a consumer facing company that never new how to market and a manufacturing company that has not evolved its practices. While these issues were at the root of recent poor results, with new management there is a significant opportunity for improvement. Key problems/opportunities include:
o Bloated cost structure – overhead creep (particularly after Ely Callaway past away – his vacuum was filled in inappropriate way with new hires and consultants)
o Poorly coordinated processes – historically, most functional areas revolved around Ely Callaway as the focal point. Now, remapping product development, supply chain, and forecasting
o Manufacturing process unchanged for 20 years – ELY is finally examining the opportunity for offshoring its high labor content (competitors started doing it years ago) as well as automation and factory layout/material handling opportunities
o Supply chain not leveraged/customer service poor – re-examining product lead times, capital investment focused on automation/cost reduction, introducing performance metrics and negotiating lead time reductions on critical components
o Poor organization structure – ELY has enhance P&L accountability, made sales report to CEO, more closely align cross departmental objectives to compensation, and included international input into product development

• New products showing traction. In 2005, new ELY products gained strong acceptance, however supply-chain issues caused shortages and shipping delays and, according to the company and contacts in the channel, significant lost opportunity. Based on channel checks, ELY’s new 2006 products in the wood, irons, and ball areas are continuing to build on this acceptance. Furthermore, ELY’s prototype models (indicators of future consumer acceptance) for both clubs and balls being used by pros are proving to be some of the most successful on tour. This is particularly important on the ball side where ELY has had negative operating margins for the last several years.

• Recent market pain, but long-term market potential. While the number of people playing golf has fallen off in recent years (in 1999, reported 27 million people played at least 1x per year vs. 24.5 million in 2004) and 2004 was the fifth straight year of low single digit declines in total rounds played, the long-term prospects for ELY remain positive. In particular, US golf fundamentals become more favorable in 7 years when the average golfer currently 43 years old becomes 50 years old (50 year olds spend 25% more time on golf than those under 50). In the medium term, Asia/Japan represents a strong growth opportunity too (for the past three years, 55% of sales have been from the US). Notably, despite the rounds played decline, overall golf industry revenue has grown in each of the last 3 years at an average of mid-single digits (2005 was >10% growth).

• Beyond operational improvements, potential strategies to unlock value. There appear to be several levers for value upside beyond operational execution over the next few years:

o A more reasonable capital structure. Given ELY’s strong FCF generation, unlevered balance sheet, and rejection of private equity offers above the current market price, it is reasonable to, over time, see the company explore a more aggressive capital structure
o Strategic alternatives. Given that ELY is the only independent in the golf industry and that its current CEO is 62 years old, it may be reasonable, once earnings power is restored, to pursue a sale of the company or other strategic alternatives
o Strategic alternatives for the ball business should it not turn around

Investment risks include:
• Competition/pricing over next few years. Can ELY take share and grow the top-line while improving margins, particularly if industry revenue growth stalls to low single-digit growth or is flat? Management’s market share gains seem reasonable given where the company was historically and recent industry revenue growth, however competitors have consolidated, have deep pockets, and there are new entrants with marketing heft. The industry is much more competitive than it was several years ago and sell-side analysts do not seem to be viewing this realistically.
• 50% of revenue every year is from new product. While ELY’s product development team is the best in the industry, the need for new innovation and product to drive sales can lead to lumpy earnings and a volatile turnaround. This is exacerbated by the fact that many analysts are very positive on the stock (2 buy, 2 outperform, 2 hold, 1 sell) and while they are directionally right on improvements they may be aggressive in the short-term and conservative in the long-term on earnings power.
• Raw material costs. Although management believes raw material costs can be offset by more efficient labor, better sourcing, and to some degree switch to different materials, ELY is experiencing sharp increases in input costs – particularly titanium and steel.

Catalyst

-Restoring earnings power
-More reasonable capital structure - increased dividend and/or share buybacks
-Exploring strategic alternatives