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Callaway Preferreds - a Downside Protected Bet

July 17, 2012 | About:
whopper investments

whopper investments

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This idea is a bit “simpler” than most of the ideas I post on this blog, but I nevertheless think it’s a pretty intriguing one, especially for investors looking to take on minimal amounts of risk or focused on yield.

The idea is to go long Callaway Golf’s (ELY) perpetual 7.5% convertible preferreds (ELYZP) (see prospectus here).

The thesis behind it is pretty simple: in a zero interest rate world, the yield on the preferred’s (8.1% at today’s price of ~$92.70) is pretty interesting. In addition, you get a bit of capital appreciation upside.

And the preferreds should be pretty safe too. The company’s horrific recent results withstanding, Callaway employs a very strong balance sheet backed with plenty of tangible assets. While they do draw on a line of credit throughout the year to fund working capital, they spend most of the year debt free and, even with the LOC drawdown, tangible assets more than double the liquidation value of the preferreds + all liabilities.

But I think you get another layer of protection. It’s hard for me to imagine that there’s not a lot of brand equity here. Callaway is one of the three best brands in golf world. This article is a bit old, but it’ll give you an idea for what we’re talking about. Or we could do some channel checks. If I look up “golf” on amazon, Callaway has two of the top ten product (number six, some power band nonsense, and number seven, a set of balls). Look up golf balls and Callaway has four of the top fifteen, including number one (the same set of balls that was number seven in “golf”). Callaway is also the brand Amazon uses as an image for its “golf store” and “golf balls” link. Finally, under “drivers”, Callaway has the number two seller (the Diablo Octane) and the number seven driver (the Diablo Octane Tour Driver). And a quick glance at the “Callaway” search shows almost all of their products are 4.5 or 5 stars out of five.

I only mention those things for one reason- they all point to Callaway having some serious brand equity with golfers.

As a deep value investor, I feel I often don’t give that “intangible” brand equity enough credit. But I think it really adds to the margin of safety here. If things got really bad for Callaway, I can’t imagine there wouldn’t be a private equity shop or three licking their lips for the change to take these guys private, lever them up, turn them around by introducing new products under the “Callaway” brand, and make a multiple of their money if successful. Or a competitor who wants to add the Callaway brand to their stable of brands. There’s just too much power with consumers to let this brand go away.

And if I’m right about that, then an investment in the preferreds isn’t just protected by all of the tangible assets (and there are a lot!)… it’s also protected by a downside “put” where if things got too bad someone would buy them out. And in the event they’re bought out in distress, the common would likely be crushed but the preferreds would recieve 100% on the dollar- that’s the beauty of being higher in the capital structure!

Are there risks? Sure- recent results have been horrific, and if the brand is permanently impaired, you can kiss that “downside put” goodbye. But I somehow doubt that’s true- IMO the brand was too strong too recently for the brand to be permanently hurt. Also, most of their competitor brands are now so big that they may not be able to acquire Callaway for anti-trust reasons. But if results got too bad, I doubt anti-trust would stop a “bail-out” merger.

There’s also the risk that things are bad for a year or two before that “put” gets exercised, and the company cuts the preferred dividend in the mean time. In that event, it would likely be a rocky ride, and your IRR would suffer a bit…. but it would still come out to be a pretty decent investment, as I still think you’d recover 100% of par + preferreds in virtually every sale or recovery scenario.

So, with all that said… why am I not buying in here? After all, I freaking love preferreds!!!!

Well, the problem here is that the upside is capped. The preferreds are now callable at 100% of par value (plus accrued and unpaid dividends). So while they are convertible…. all of the upside from the convert period had passed!

I personally consider my cost of capital to be 15%. If I don’t think an investment can make me 15% per year (or greater) over my holding horizon, then I don’t have room for it in my portfolio. And while Callaway offers nice downside protection, there’s really no way you’re making more than 9-11% per year w/ the preferreds at these levels.

So they’re a pass for me… for now. I would certainly consider buying them if they got down to the low 80s in a market sell off, or if things got really bad at the company, causing them to cut the dividend and tank the preferreds price.

All that said, I do think they represent a very attractive investment for investors looking for a solid risk / reward that pays off a good yield and has great downside protection. Or for an investor with access to much cheaper leverage than I have access to- if you could borrow at 4% and invest in these yielding 8%+ today, plus a little capital appreciation, that would be quite the arbitrage opp (provided you are confident there will be no div cut!!!!).


Rating: 4.1/5 (7 votes)

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