CALLAWAY GOLF

Australia, Canada, China, Europe, India, Japan, Korea, Latin America, New
Zwaland, South East Asia, United States

Irrational Market Pricing: The Mystery

Of Callaway Golf
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.

My name is Alex Morris. I am a senior at the University of Florida and will be

graduating with a degree in Finance and a minor in Real Estate in April of 2011. The
basis of my investment philosophy is owning pieces of businesses with strong long
term fundamentals trading at a discount to intrinsic value, with an emphasis on
patience and concentrated positions. I search for companies within my circle of
competence that posses a sustainable competitive advantage, as well as managers
that display the highest level of integrity, possess superior capital allocation skills,
and eat their own cooking. I am comfortable putting a significant portion of my
capital into one or two investments, and don't mind waiting years ...More for an
attractive opportunity in a great business to present itself.