Share tip of the week: golf company set for an upswing

By Paul Hill Jul 24, 2009

Paul Hill

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Investors often rely too much on current performance when valuing stocks that operate in cyclical industries. I prefer to look through the inevitable peaks and troughs, and focus on sustainable returns over the economic cycle.

Take Callaway. It sells golf equipment such as clubs (61% of revenues), balls (20%) and accessories (19%), under the Callaway, Big Bertha, Odyssey, Ben Hogan and Top-Flite brands.

These are all names well known to the golfing fraternity, thanks to endorsements by professionals such as Phil Mickelson, Arnold Palmer and Annika Sörenstam. Turnover is split 50/50 between the US and overseas. Its chief rivals are Nike, TaylorMade, Ping, Mizuno and Titleist.

Unsurprisingly, given the grim economic backdrop, Callaway is suffering. The global golf market is expected to shrink by 15-20% this year, and the company has been hit by a combination of retailer destocking, a strong dollar and weaker consumer demand.

However, this is what you'd expect, and the company is aggressively discounting and slashing costs to combat the downturn. Yet this logical chain of events has unnerved Wall Street, leading to a round of analyst downgrades, in turn sending the shares down towards 16-year lows.

Callaway Golf (NYSE: ELY), rated a BUY by KeyBanc Capital

This sell-off looks far too harsh. Firstly, despite the headwinds, the business has managed to grab market share and should broadly breakeven this year. The group also boasts a strong balance sheet. In June it raised $140m from convertible preference shares, which should provide more than enough firepower to survive the most challenging environment. Throw in the growing number of retired baby boomers – who buy more than half of all golf gear – and there are the makings of a strong rebound when the storms subside.

So what's the business worth? The board expects 2009 turnover of between $927m to $950m. Assuming long-term operating profit margins of 10% (versus the company's internal target of 15%) and a ten-times multiple, we get an intrinsic worth of about $12 a share. Indeed, at today's levels, the stock is trading at a 20% discount to net tangible assets at $6.40 a share and appears to assign no value at all to its brands.

But were are the possible sand-traps? Along with the cyclical nature of the sports-leisure industry, the firm is also exposed to currency fluctuations, changing technology, fickle consumer tastes and tough competition. But these risks are more than factored into the rock-bottom price.

And when the economy does pick up, buying now could prove very profitable for adventurous investors. And even if the group's woes continue, a takeover by a larger rival looks on the cards. Second-quarter results are due out on 29 July.

Recommendation: high-risk BUY at $5.10 (market cap $330m)

• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

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Published in Tips & advice | More articles by Paul Hill

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