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Alex Morris
Alex Morris

Irrational Market Pricing: The Mystery of Callaway Golf

January 14, 2011 | About:

Sometimes the market really does baffle me. Investors search high and low for potential profits by predicting (I prefer the word guessing) complex and highly uncertain figures like 10 year growth rates for cloud computing, when plain and simple common sense business opportunities are staring them in the face. A great example of this phenomenon can be found in the current state of the golf industry (I have written extensively on this subject, so feel free to check out my others discussions about the state of the industry and certain specific events here).

Golfsmith International Holdings (GOLF) released preliminary results on Wednesday, and provided the first case for optimism among investors in the golf industry in quite some time. For the fourth quarter ended January 1, 2011, revenues increased 14.2% to $72.9 million (dubbed by some analysts as “their best fourth quarter in four years”), along with a 4.1% increase in revenues for FY2010 to $351.9 million. While these improvements may not seem like much and are still below FY2008 revenues, they are huge step in the right direction for an industry that has been struggling to find any sense of mean reversion (On a side note for interested readers, part of the success has been due to less competition; be on the lookout for a future article dissecting Dicks Sporting Goods (DKS), which also has a big position in golf retail).

As noted by Golfsmith CEO Marty Hanaka, this is a glimmer of light after a succession of nothing but dark clouds. “The environment is better,” Hanaka said. “People are feeling better about their personal balance sheets and the equity markets and there’s pent up demand out there.” The precipitous decline in spending in the golf industry (there should be a picture of some golf clubs under “discretionary spending” in the dictionary) has been exacerbated by the struggles of its best customers. As noted by Callaway Golf (ELY) George Fellows in November, two of the most heavily affected segments of the economy (automotives and financial services) also are two of the biggest players in golf sponsorship and corporate involvement. While these two industries don’t encompass all players, they do account for a substantial part of the golf community; their continued efforts and return to a sense of normalcy in the market should also help the manufacturers and retailers looking forward.

Investors have responded to the news for GOLF, pushing the stock nearly 60% higher in two short days. On the other side of the coin, Callaway (the best example of a pure golf company; the size of golf operations at Nike and Adidas make them poor indicators) has inched up a mere 0.75%. While the news hasn’t directly suggested that ELY is the benefactor of better-than-expected Golfsmith sales, new technology and the development of game changing products should. Golf Digest’s “Hot List”, the industry standard for new product research, has once again ranked Callaway’s 2011 product line as the leader in product development, awarding the company more medals than any other competitor for the fifth consecutive year. Without going into too much detail on specific product lines, it is safe to say that Callaway is prepared to benefit from any industry growth.

Eighteen months ago, the industry as a whole was in freefall. Callaway’s results for quarter end June 30th, 2009 saw revenues decline 17.4% year over year and net income decline by more than 50%. Callaway was even forced to go so far as issuing preferred shares in order to remain within the requirements of its financial covenants. Despite the clear headwinds and issues that faced the company, the market was still willing to bid the price up to $8/share less than a month after these results were reported. Fast forward to today: with a much brighter outlook for the industry as a whole and a much stronger balance sheet, one would assume the expectations for future growth and (subsequently) the stock price to be significantly higher. Instead, Callaway trades at a nearly identical valuation in comparison to 18 months ago.

Let me be perfectly clear about one thing: the golf industry is still at a crossroads, and needs to continue working away from “elite status” and pricing issues; the recent downturn has made this problem clear to most courses, which, like any enterprise, will need to adjust their business model to meet consumer demand (or go out of business if they want). Along with international growth in expectation of the 2016 Olympics, I believe these two key macro issues point towards a much brighter future for the golf industry in the next 3-5 years.

For investors, take the time to look at Callaway (and the Fortune Brands (FO) split off of Titelist/FootJoy if it happens fairly soon); if the recent announcement by Golfsmith is any indication for the upcoming golf season, Callaway may be a great place to invest your capital for the next couple of years.

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

Rating: 3.5/5 (15 votes)


Kfh227 - 6 years ago    Report SPAM

I see ELY as fairly valued. Definitely nothing to cheer about. Besides, their FCF numbers are a mess year to year.

As for GOLF, I am afraid that that comapny is to scary for me. I like more obvious values. Well written article though. It did open my eyes to an area that should recover soon. (5 stars)
Alex Morris
Alex Morris - 6 years ago    Report SPAM
Thank you for the comment Kfh227. Based on the fact that you see ELY as fairy valued, is it safe to assume you believe it was overvalued 18 months ago? Interested to hear your thoughts. Thank you
Alex Morris
Alex Morris - 6 years ago    Report SPAM
For interested readers, this is a great discussion called "A Formula For the Renaissance of Golf", written by Adams Golf founder Barney Adams. Enjoy:

Graemew - 6 years ago    Report SPAM

Having looked at the ten year figures on gurufocus for ELY, Callway, it is clear that this is not growth stock...with no increase in earnings since around 2000 and with some years of losses as well. I consider the stock to be currently overvalued. I wouldn´t buy it even at $6.00
Alex Morris
Alex Morris - 6 years ago    Report SPAM
Thank you for your comment Graemew. There is really no question that Callaway is not a growth stock; with that being said, there can be period where demand for it's products increases for a period of time. I believe the next five years is such a period. While I disagree with it being overvalued, I definitely don't think it is a bargain above $8/share.
Kfh227 - 6 years ago    Report SPAM
As an aside, from things I hear about the future of water, I really think that golf is doomed long term.

As for ELY and valuation, I think it was a time to buy when it dropped under $5 about 18 months ago (July 2009). The thing is, I don't think I would have considered it then for the same reason I would not now. The numbers year to year are all over the place and it's easier just to find a company that doesn't havesuch characteristics.

A 50% margin of safety is needed for ELY so I would require that a stock like ELY be in the low $4s to buy.
Lothario premium member - 6 years ago
I don't see anything irrational about it's market price.
Alex Morris
Alex Morris - 6 years ago    Report SPAM
Lothario and Kfh227,

Thanks for the comments. My point was not that the current valuation is short-changing ELY; it was instead that based on the changes in both the company's business and the state of the industry, it is irrational that the valuation for ELY is identical to 18 months ago. May still disagree, but just wanted to clarify. Thanks again for commenting.

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