Callaway Golf Company
Q3 2007 Earnings Call Transcript

Published: 2 Nov 2007

[Operator:]

Welcome to the Callaway Golf third quarter financialresults. (Operator Instructions) I would now like to turn the conference overto the company's Chief Financial Officer Brad Holiday. Please go ahead, sir.

[Brad Holiday:]

Thank you and welcome everyone to Callaway Company's thirdquarter 2007 earnings conference call. I'm Brad Holiday, Chief FinancialOfficer of Callaway Golf Company. Joining me today is George Fellows, Presidentand CEO of the company. During today's conference call, George will provide someopening remarks and I will provide an overview of the company's financialresults and we will then open the call for questions. I would like a point out that any comments made about futureperformance, events or circumstances including statements related to estimated2007 sales, gross margins, operating expenses and earnings per share, theachievement of three-year financial targets, new product shipments, and the company'sestimated 2007 CapEx and depreciation and amortization expenses areforward-looking statements subject to Safe Harbor protection under the federalsecurities laws. Such statements reflect our best judgment today based oncurrent market trends and conditions. Actual results could differ materiallyfrom those projected in the forward-looking statements as a result of certainrisks and uncertainties applicable to the company and its business. For detailsconcerning these and other risks and uncertainties, you should consult ourearnings release issued today as well as Part 1, Item 1(a) of our most recentForm 10-K filed with the SEC, together with the company's other reportssubsequently filed with the SEC from time to time. In addition, during the call in order to assist interestedparties with period-over-period comparisons on a consistent and comparablebasis, we will provide certain pro forma information as to the company'sperformance, excluding charges associated with the company's gross margininitiatives, the integration of Top-Flite operations, and the restructuringinitiatives announced in September 2005. In order to evaluate the company's core operatingperformance from a cash generation perspective, we will also provideinformation concerning the company's earnings before interest, taxes,depreciation and amortization. This pro forma information may include non-GAAPfinancial measures within the meaning of Regulation G. The earnings release weissued today includes a reconciliation of such non-GAAP financial measures tothe most directly comparable financial measures prepared in accordance withGAAP. The earnings release is available on the Investor Relations section ofthe company's website at www.CallawayGolf.com. I would like to now turn the call over to George for a fewopening remarks.

[George Fellows:]

Thanks, Brad andthank you all for joining us. We continue to be pleased with the company'sprogress on a broad range of fronts, both near and longer term. Consumer andtrade acceptance of our 2007 lineup has been outstanding, with significantshare gains in almost all major categories. Just to quote a few, in the U.S.,our wood share on a year-to-date basis is up 2.4 share points, and it's up 3.9share points in the UK.In irons in the U.S.we're up almost one share point, and in the UKup 2.6 share points. Revenue growth has been particularly strong, furtherreflecting the positive consumer and trade response to the product line, whileprogress on margin improvement is proceeding on plan with year-to-date marginsat 45% versus 40% in 2006. Customer service continues to improve while inventories arebeing materially reduced. Inventories at the close of the quarter were down $28million, somewhat more than the target communicated earlier this year. Our international business is ramping up with year-to-datesales plus 19% versus 2006. Our overall profitability is solidly growing withtrailing 12-month EBITDA up 139% to $136 million. We are particularly pleased also with progress on keylonger-term issues. Additions to our organization have further enhanced ourgreat internal talent, and enabled the organization to raise the bar withregard to our ability to compete effectively. Our process improvements inproduct development and manufacturing and supply chain have improved not onlyour ongoing profitability but also our ability to reproduce our positiveresults longer term. Testament to this is the robust new products pipelinecurrently in place extending to 2010 and beyond, as well as the very positiveearly reception to the 2008 product line currently being introduced. Now as happy as we may be with our results to-date, there'sstill lots to be done on a number of fronts. Among the many key items, thedrive for additional margin improvement and working capital reductions remainin full force with more detail and new higher targets to come early next year. Restoring Top-Flite to health remains a top priority, andwhile progress to date is gratifying, we are in no way where we need to be. Explorationof other growth opportunities that we've talked about briefly in the pastcontinue and we hope to provide some insights as to progress also early nextyear. Obviously, there are many more imperatives than just these. So to sum up some of the key metrics through three quartersof 2007, our net sales are up 13% to $950 million, a record for the company;our gross profit is up 27%; our trailing 12-month EBITDA, as I mentioned, is upfrom $57 million last year to $136 million this year; we have repurchased 6.2million shares of stock for $104 million through nine months. Now looking to the balance of the year, we will be raisingour estimates for 2007 for the third time, and we feel we are well on track toachieving the three-year guidance given earlier this year. I'd like to now turn the call back over to Brad.

[Brad Holiday:]

Thanks, George. In reviewing the financial results for thequarter, we achieved consolidated net sales of $236 million, a 22% increasecompared to last year sales of $194 million. Net income for the quarter was $1million compared to a loss of $12 million last year and earnings per share was$0.02 versus a loss of $0.18 per share in the prior year. On a pro forma basis excluding 2007 after-tax charges of$0.04 for gross margin initiatives that we announced last November, and 2006after-tax charges of $0.01 for Top-Flite integration charges and $0.01 forrestructuring charges, our pro forma earnings per share for 2007 increased to$0.06 compared to a loss of $0.16 in 2006. Through the first nine months, we achieved record sales of$950 million; an increase of 13% compared to last year, and earnings per shareof $1.03, an increase of 110% compared to $0.49 last year. On a pro forma basis, excluding 2007 after-tax charges of$0.07 for gross margin initiatives, and 2006 after-tax charges of $0.04 forTop-Flite integration charges and $0.01 for restructuring charges, our proforma earnings per share for 2007 increased 104% to $1.10 compared to $0.54 in2006. We are very pleased with these results, which reflect our strong 2007product line, as well as the initiatives we have been focused on this year toimprove our gross margins and business processes. Taking a quick look at overall sales by product category,our wood sales for the quarter increased 29% to $56 million compared to $44million in 2006. This increase was due to continued sales momentum of ourFusion platform of drivers offset by a slight decline in Fairway Woods.Year-to-date, our woods category has increase 19% to $271 million compared to$227 million last year. Sales of irons and wedges were $65 million compared to thirdquarter sales last year of $53 million; an increase of 23%. A majority of thisincrease was driven by the success of our X-series irons offset slightly by adecline in our Fusion line of irons, which are in the latter part of theirproduct life cycles. Year-to-date, our irons category has increased 7% to $261million compared to $243 million last year. Golf ball sales were $49 million for the quarter; anincrease of 15% compared to last year’s sales of $43 million. This increase wasdriven by strong sales of Callaway-branded golf balls, including several newproducts but in particular, our HX Hot model, along with increases in ourTop-Flite business due to the success so our D2 golf ball, which has continuedto gain momentum throughout the year. Year-to-date, our total golf ball sales were$175 million; an increase of 4% compared to last year, despite a decline inrounds played in the U.S. this year. Putter sales for the quarter were $22 million compared to$23 million last year. Year-to-date putter sales have increased 3% to $88 million,maintaining the #1 position in market share. Accessories and other sales have increased by 38% for thequarter driven by our gloves, bags and footwear products. Year-to-dateaccessories and other sales have increased by 34%. Turning to our regional breakout, U.S.sales were $124 million for the quarter compared to $103 million last year, anincrease of 21%. International sales were $111 million, an increase of 23%compared to $91 million last year. All regions experienced sales growth withthe strongest results in Europe and Canada. Through the first nine months, U.S.sales were $513 million; an increase of 9%, with international sales increasing19% over last year to $438 million. All regions have experienced positive salesgrowth through the first three quarters, both in U.S.and local currencies. Gross margins for the quarter were 40% compared to 35% lastyear. Excluding charges for gross margin initiatives in 2007 and integrationand restructuring charges in 2006, pro forma third quarter gross margins were42% of net sales compared to 36% in the prior year. A majority of this increasing gross margin percentage is dueto our gross margin initiatives with the balance due to a favorable mix ofhigher margin products, primarily our X-series irons, Fusion drivers and ourgolf ball business. Year-to-date, gross margins were 45% compared to 40% in2006. Adjusted for gross margin initiatives in 2007 and integration andrestructuring charges in '06, pro forma gross margins increased 5 percentagepoints to 46% compared to 41% last year. Operating expenses for the quarter were $93 million comparedto $85 million last year, but as a percentage of net sales, declined to 40%compared to 44% in 2006. The dollar increase is due to increase marketingexpenses, employee incentive compensation related to improved financialresults, legal costs associated with enforcing our intellectual propertyrights, and higher selling costs associated with higher revenues. These increases were partially offset by the gain recognizedon the sale of the building here on campus. Year-to-date operating expenseswere $311 million compared to $281 million last year, with a slight improvementas a percent of sales. Moving to the balance sheet, net working capital increased6% compared to last year. This increase was driven by higher receivablesassociated with the higher net sales for the quarter and a decrease in ouroutstanding line of credit. Excluding the balance on our credit facility, networking capital decreased 13% driven by a reduction in inventory. Consolidated net receivables increased to $165 millioncompared to $138 million last year due to the higher net sales. Consolidatedday sales outstanding improved to 64 days compared to 66 days last year.Collections on AR remain good and the overall quality of our AR is good. Net inventories were $214 million compared to $242 millionlast year; a decline of $28 million. This is a byproduct of some of our grossmargin initiatives and is in line with the $20 million to $25 million intargeted reductions that we communicated earlier this year. From a cash generation perspective, as George mentioned,trailing 12-month EBITDA through September increased 139% to $136 millioncompared to $57 million for the same period last year. This increase is aresult of many top and bottom line initiatives we've implemented over the pasttwo years. CapEx for the quarter was $6 million and we estimate total2007 capital expenditures to be approximately $35 million to $40 million, whichis slightly lower than our forecast from last quarter due to a delay in our Carlsbadbuilding consolidation project. Depreciation and amortization was $10 million for thequarter. Our estimate for the full year remains at approximately $35 million,consistent with our forecast last quarter. During the third quarter, we repurchased 4.4 million sharesof stock for $75 million at an average price of $16.87 per share. Year-to-datethrough September, we have repurchased 6.2 million shares of stock for $104million at an average price of $16.68 per share. We have $22 million of the$100 million authorized by our board in June of this year remaining at the endof the quarter. As George mentioned, we are raising our full year guidanceagain with sales increasing to a range of $1.095 billion to $1.105 billion, andpro forma fully diluted earnings per share to $0.85 to $0.89 based on 68million shares outstanding and excluding approximately $0.08 per share for ourgross margin initiatives. This is the third time we've raised our forecast thisyear, and in addition to this increase, we are also narrowing the range a bit,given the fact that we're now three quarters of the way through the year. This new outlook compares to our last estimate from lastquarter of sales ranging from $1.07 million to $1.08 billion and pro formafully diluted earnings per share of $0.78 to $0.84 based on 70 million sharesoutstanding. Please keep in mind that the fourth quarter is typically thesmallest revenue quarter of the year and net-net sales in 2006 included severalnew products that were introduced during the fourth quarter equalingapproximately $30 million of sales. Our forecast includes limited shipments ofnew products during the quarter, with the exception of some products targeted atholiday sales opportunities. Our full year forecast assumes that gross margins willcontinue to be approximately 5 percentage points better than last year. It alsoassumes that annual operating expense will be approximately $45 million higherthan last year, consistent with our last forecast, primarily due to higheremployee incentive compensation associated with our improved financial results,higher marketing and advertising expense, higher legal expenses to enforce ourintellectual property rights, and higher selling expenses due to increasedrevenues. Fortunately, because we have been able to deliver highergross margins than we originally had estimated, we have been able to invest inand fund many of these initiatives and still deliver much improvedyear-over-year financial results. We would now like to open the call for questions.

[Operator:]

Your first question comes from Bill Chappell - SunTrust.

[Analyst for BillChappell:]

First of all on the gross margin initiative, it appearsyou're possibly seeing some of that ahead of schedule. Is that goal still the$50 million to $60 million in savings you originally set out? Is it possibleyou can see some upside to that?

[George Fellows:]

It is essentially consistent with what we originally hadprojected. We are, as we indicated before, continuing to look at additionalprojects. As I indicated in my brief comments, we believe we will be coming outwith higher targets in the early part of next year.

[Analyst for BillChappell:]

As far as the $30 million in new product launches, can youremind us exactly which products those are in?

[Brad Holiday:]

We did the HX Hot Fairway Woods was one of them. The Xhybrids were last year. There was some X-20 irons shipped in order to meet someof the early January shipments to some of our key accounts. There was a new SMUball for the mass channel that was launched in December. Those were the biggerones.

[Operator:]

Your next question comes from John Shanley - Susquehanna FinancialGroup.

[John Shanley:]

George, staying onthis movement of products out of the fourth quarter, new product development,would it be fair for us to assume in our models that we could add a fairlysubstantial additional amount to our first quarter models if you're movingproducts had in the past been developed and initiated in the fourth quarterinto the more profitable first quarter?

[George Fellows:]

No, not really, Actually'07 reflected exactly what you're discussing. We've been striving to change theentire new product schedule so that more of the product was shipped earlyenough to catch the entire season. In '07, we were largely successful at doing that. Whatessentially that has done is shifted a good deal of the new product shipment aswell as the consumer takeaway into the earlier periods of the year. So, thisyear by not shipping a great deal in the ’08 would be the second time that we'dbe doing exactly that.

[John Shanley:]

I didn't understand that. The other question is when aremost of the new products likely to be introduced into the marketplace?

[George Fellows:]

Well, the new products as we're currently scheduled rightnow begin shipment, a few of them in January, but mostly the February/Marchperiod and some will slip into April as well. Again, we've spread them out inorder to get the maximum effect in terms of sell-in and get the appropriateattention at retail to make sure they're merchandised properly.

[Brad Holiday:]

John, we've alreadysaid that if we can get them shipped out and plan to ship them into themarketplace prior to the Masters, which is kind of the kickoff for the season, that'skind of the sweet spot for us in terms of introducing them to the marketplace.

[John Shanley:]

Can you give us an idea of the magnitude of the new productintroductions for next year versus what you introduced this year?

[George Fellows:]

Most of them are thesame standard size.

[John Shanley:]

About the samenumber?

[George Fellows:]

Only kidding, John.Sorry, that was a weak attempt at humor. No, we have really a rather fullschedule of new product activity, albeit somewhat different than this year. Asyou recall in '07, we had three new drivers. This year we have essentially onewith some updates on some others. We have a rather full schedule of Fairway Woodsand hybrids. Last year we had the X-20 launch and the BB07 irons. This year wehave Fusion irons. So essentially we have touched all of the categories withsome new products, albeit a different mix than they were in '07. Of course wehave a very large new ball introduction, both on the Callaway side as well ason the Top-Flite side.

[John Shanley:]

On Europe, business there seems to bedoing extremely well. You're up 40% year-to-date in sales. Can you give us aninsight in terms of are there specific countries that are particularly doingwell for you? Are the grounds played and the retailer interest in golfequipment growing in terms of the importance of the overall market? Are youjust gaining share from other brands that are in the market?

[George Fellows:]

Well, we're gainingsubstantial share. I think I quoted a couple of numbers early on from the datasources that we have. But the increases in Europe are pretty much across theboard. Their weather situation is just a little different than it was lastyear. Last year they started off terribly with a very wet and cold early partof the season and then a very hot middle part of the season. This year, the badweather came at a different point. So the weather has somewhat improved as faras Europe is concerned this year, but not materially. There,it's just that we're doing extraordinarily well. The products have been verywell received literally across the board.

[John Shanley:]

Are there certaincountries that are outperforming others in the marketplace?

[George Fellows:]

Well, that's always the case. But again, our larger piecesof business are the UK,the Scandinavian countries, Germany,etcetera. It's a very broad-based performance on the part of Europethis year.

[John Shanley:]

Are you evaluating further real estate consolidation in Carlsbador is that just a one-shot deal?

[George Fellows:]

We're always looking at ways to try to make our operation abit more efficient. Right now as we currently sit, given our immediate plans, Iwould expect that this would be it. But again, as additional things happen inthe operations area, that might indeed lead to further consolidation down theroad.

[Operator:]

Your next question comes from Rommel Dionisio - WedbushMorgan.

[Rommel Dionisio -Wedbush Morgan:]

Just a question on inventories. I think in your comments,George, you talked about how you're seeing somewhat of a timing shift in '07and in '08 with regard to new product launches. So should we use the year end'06 inventory level as sort of a benchmark to track you to see how you do atyear end '07? Because I remember on last year's conference call for the fourthquarter you talked about how you had three new woods coming out and inventorieswere up a fair amount at that point.

[George Fellows:]

We typically will have an increase in inventories as we getto the end of the year, building for the early next year shipments. So youwould expect the third quarter to fourth quarter inventory to rise. You shoulduse, however, the '06 ending inventory as a base to measure how much we've beenable to reduce the overall inventory. So while the number will be up from thethird quarter as it is typically because of the pattern that we have to followfor production, it will be down '07 to '06.

[Brad Holiday:]

Rommel, remember we had targeted to be down $20 million to$25 million by the end of the year.

[Rommel Dionisio -Wedbush Morgan:]

I think in your restructuring discussion last year youtalked about completing the automation of production of putters and woods andirons by summer. Could you just give us an update on the progress there?

[George Fellows:]

No, we didn't saycompleted. We said that we're continuing to expand it across a broader portionof our line and that is indeed what has happened there. There are designrequirements in order to automate and that requires new lines. So it takes aperiod of years until you ultimately redesign things so that they're allautomatable. But a larger percentage of our product is now at least partiallyassembled automatically than it was a year ago. And next year, it will be evengreater.

[Operator:]

Your next question comes from Jeff Blaeser - Morgan Joseph.

[Jeff Blaeser:]

A question on the three year plan. Are you stillcomfortable? Obviously you had some good progress this year with the three youput out earlier in the year. If so, do you expect it to be gradual over thenext two years, particularly the mid-teens EBIT margin expectations?

[George Fellows:]

At this point as weindicated, we're quite comfortable that we're well on our way toward achievingthe objectives that we delineated earlier this year. We will, in fact, becoming out with our revisions to the three-year forecast early next year inaddition to coming out with guidance for the year '08 in the early part of the year. So Ithink I'll reserve the detail on that until that point.

[Jeff Blaeser:]

It looks like on the free cash flow or the cash fromoperations, you're a little bit over $100 million year-to-date. Do you have anyexpectations for the year end and could it be closer to the $100 million freecash by the end of this year? Is that possible?

[Brad Holiday:]

Well, we're obviously pacing slightly ahead of where we hadprojected for three years. So, we haven't really given a forecast for the year.But certainly, as we start to tie up more inventory here towards the end of theyear, we're going to be close to the levels we're at now, Jeff, to be honestwith you.

[Operator:]

Your next question comes from David Wells - AvondalePartners.

[David Wells:]

First off, just in terms of the operating margin improvementthat you saw on a year over year basis in Q3, how should we think about thatgoing into the fourth quarter? Should that continue or should we see someexpense deleverage?

[George Fellows:]

You should feel very good about it. No, we would expect that we're going to continue to keeppressure on the overall margin. We are quite comfortable delivering exactlywhat we said we were going to deliver earlier in the year. As I indicated, I'dhold comment on what we think the future holds until the early part of nextyear. But I would not be surprised if it's pretty much in line with what you'veheard before.

[David Wells:]

In terms of mix going into the fourth quarter, is there anycolor that you can give there about expectations?

[George Fellows:]

Well again, remember the fourth quarter is a relativelysmall quarter for the industry based on the seasonality. We are a higher-pricedline. The people that come in and buy, other than the gift givers if you will,at the end of the year are fundamentally looking for bargains and markdowns andthings of that sort. That's not an area that we participate in particularlyheavily. So I don't know if that gives you enough color on it. But we are notselling much in the way of closeouts at the end of the year.

[Operator:]

Your next question comes from Tim Conder - Wachovia.

[Tim Conder:]

My congratulations, gentlemen, on good execution. Was it adifferent tax rate or not, Brad, on the sale of the building?

[Brad Holiday:]

No different taxrate. We had some tax audits that cleared up during the quarter, Tim. And becauseof just the low level of profitability during the quarter it ends up impactingthe tax rate more than normal.

[Tim Conder:]

How should we think about that on a go-forward basis?

[George Fellows:]

I've always kind of just targeted around 38.5% as the numberthat I would continue to use. I mean, there will be some fluctuations justbased on how we close out audits and things that come through, but generally Iwould just use that.

[Tim Conder:]

A good recovery, gaining share in Europe.Is that also fair in Japan?Between those major geographic areas, could you break out share gains versusthe currency?

[George Fellows:]

Well, to talk to theshare gains, yes. To the extent that we get share data in the Asian markets andthat, of course, is fairly limited, but our share gains had been marked in Japanas well so that the gains that we're seeing in the business in Asiaare local currency gains for sure. Clearly there have been FX effects on thosenumbers and I think Brad can give you some color on the FX.

[Brad Holiday:]

Tim, I would justtell you that with market share, I mean we get the market shares, they don'treally tie it back to U.S. dollars but on the quarter, FX had a positive impactof $4.7 million and for the first nine months, about $16 million.

[Tim Conder:]

All on the net line there?

[Brad Holiday:]

That's net sales.

[Tim Conder:]

Anything looking at it on the EBIT perspective?

[Brad Holiday:]

Well, that gets a little bit tougher, but you've got toassume the favorability we get on the top line costs us more in operating expenseso it has cost us more there. I don't have a number that we've ever reallyshared with you guys because it's just a little hard to really fine-tune. Butgenerally a weaker dollar will have a positive impact on the bottom line untilyou reach the point where pricing becomes an issue. We have seen one case ofthat this year in our Koreamarket where we actually took some pricing down. That certainly had a negativeimpact on the bottom line.

[Tim Conder:]

Was there an investments made, an additional investment inan existing venture or a new venture during the quarter?

[George Fellows:]

We actually providedsome additional credit facility to the top golf entity to the tune of, I think,it was about $2.5 million. So that was the additional investment.

[Tim Conder:]

What's the plan going forward there?

[George Fellows:]

Well, we're still a minority partner. And they arecontinuing to expand the number of facilities that they have. They opened onein roughly September/October in Dallas.They have another one scheduled to open up soon in Chicago.We are a minority interest. We continue to work with them and try to takeadvantage of branding opportunities and really just seeing if we can bring morepeople into the game of golf.

[Operator:]

There are no further questions in queue at this time. I'llturn it back to you.

[George Fellows:]

Well, again, I'd like to thank you all very much for joiningus. Clearly, we're pleased with the progress the company has had to-date.Obviously, we are not at all satisfied that we've come anywhere close to ourcapabilities and the organization is working very, very hard to be able toraise that bar. Again, just to remind you in the early part of the year Ithink we'll be setting some additional targets, higher targets for us in anumber of different categories. We'll be looking forward to communicating themto you then. In the meantime, enjoy the fourth quarter.