Topgolf Callaway Brands Corp (MODG) 2002 Q3 法說會逐字稿

Good afternoon.

My name is Latasha, and I will be your conference facilitator today.

At this time I would like to welcome everyone to the Callaway Golf third quarter 2002 earnings call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer period.

If you would like to ask a question during this time, simply press star then the number 1 on your telephone keypad.

If you would like to withdraw your question, press the pound key.

Thank you.

I would now like to turn the call over to Ron Drapeau and Brad Holiday.

You may begin your conference.

Thank you.

Good afternoon, this is Brad Holiday, and thank you for joining us to discuss Callaway Company's financial results for the third quarter of fiscal 2002.

During today's conference call, Ron Drapeau, Chairman, President, and CEO, will provide an overview of our financial results and discuss current trends and insights.

I will provide detailed comments regarding our third quarter and year-to-date financial results, after which we will open the call for your questions.

During the call we will comment on current results compared to last year.

Before we begin, I would like to point out that any comments made about future performance, events, or circumstances, including estimates of sales and earnings-per-share information for 2002 are forward-looking statements subject to Safe Harbor protection under the Federal Securities laws.

Such statements reflect our best judgment today based on current market trends and conditions and are subject to certain risks and uncertainties which could cause actual results to differ materially from those projected in the forward-looking statements.

For details concerning these and other risks and uncertainties, you should consult our most recent Form 10Q filed with the SEC as well as the company's other reports subsequently filed with the SEC from time to time.

With that, I will turn the call over to Ron.

Thank you, Brad.

Welcome, everyone, and thank you for joining us.

Most of the listening audience knows the company well.

For those relatively new to the company, let me start by saying it has been a challenging last 12 to 15 months.

We expected that our industry would improve slightly from the effects of 9/11 and the resulting consumer apprehension at the end of last year.

We planned our business based on these assumptions and communicated to our shareholders that, with everything being equal and no new bad news, we would beat 2001 results.

Well, everything is not equal, and bad news came.

The myriad reports of corporate wrongdoing on top of a tough economic picture in the U.S. and Japan, combined with the meltdown of personal net worth with the stock market trading near the lowest point in five years, has directly affected our consumers.

We have seen similarly dismal economic conditions in Japan, albeit for different reasons.

In addition to those general economic woes, our industry suffers from stagnation in participation, rounds played being down again this year, and by the USGA's reversal of the proposed compromise on the COR and driving clubs, which added confusion and concern to the consumers that were in the buying mood.

As the industry leader, we are not immune from the fallout of these market conditions.

In fact, you would expect the industry leader to be affected the most.

Yet for the first half of 2002, we found ways to overcome these challenges.

As the third quarter developed, we saw that deteriorating consumer confidence was impacting sell-through of golf products and reorders were slower than expected.

Our competitors reacted with aggressive pricing in support of market share at all costs.

We have taken a variety of actions to address sales but more importantly, earnings, which we will discuss later in this call.

Despite these negative conditions that I have just mentioned, we were able to achieve $160 million in sales in the third quarter, down 18 percent from a year ago.

On those sales we delivered 3 cents per share from operations and 19 cents per share including the reversal of our warranty reserve as previously identified during our second quarter conference call and as stated in our September 26th press release on third quarter and full-year guidance.

Last year's results were 20 cents per share from operations and 9 cents per share, including a non-cash charge for a since-terminated long-term energy supply agreement.

Year-to-date sales were $669 million, down 6 percent from 2001.

Cumulative earnings per share were $1.19 and 92 cents for 2002 and 2001, respectively, a 29-percent increase.

Excluding the non-cash items discussed earlier, cumulative earnings per share were $1.03 and $1.12 for 2002 and 2001, a decline of 8 percent on the 6-percent decline in sales I already mentioned.

In the current quarter, sales trailed a year ago in all products except putters and accessories where our 2-Ball White Hot putter has been a smash hit.

Year-to-date sales are ahead in all product categories except titanium metal woods, which was expected, due to the normal product lifecycle as both our ERC II and VFT Metal Woods are in their second year.

We have attempted to offset this decline by introducing our new Great Big Bertha II drivers in September.

Early indications from tour play and reactions from our customers and consumers are positive, which is encouraging.

We also have adjusted pricing on golf balls, allowing us to compete against the market leader.

We have achieved credibility for our product with tour success, gaining the number 2 position on the PGA tour and six major professional tours around the world.

This price reduction, which negatively impacted gross profit, along with an increase in advertising expense in the quarter, resulted in lower operating profits when compared to last year.

During the last year we have continuously addressed our cost structure and expense levels.

The results of these actions have enabled us to improve gross margins in golf clubs, despite reduced selling prices.

As a matter of fact, we have reduced our labor and overhead costs on clubs by 13 percent this year and, on average, by 9 percent over the last three years.

Additionally, year-to-date we have reduced our selling G&A by 5 percent against a 6-percent decline in sales, and we are not finished.

During the fourth quarter we will announce the results of the ongoing efforts to eliminate losses in the golf ball business as well as examination of all the expense elements in the club business to ensure that it's properly structured in this poor environment.

With that, I will hand the call over to Brad to review our financial results in more detail.

Thanks, Ron.

Let me start by saying that all references to earnings I will cover in my remarks exclude the effects of last year's non-cash charge associated with the since-terminated long-term electricity agreement and the reversal in warranty reserve taken this year.

I will talk more about the warranty adjustment later.

Having said that, third quarter sales declined 18 percent to $160 million and earnings per share declined to 3 cents from 20 cents last year.

Our sales were impacted by general industry-wide weakness with declines in most categories and regions.

Sales of woods during the third quarter declined 31 percent to $56 million compared to $81 million last year and comprised 35 percent of sales.

The decline in wood revenues comes at the end of the product lifecycle for our Hawk Eye VFT and ERC II Titanium woods and due to the continued weakness in Japan.

The sales decline was only partially offset by limited initial shipments of our new Great Big Bertha II.

Year-to-date sales of woods have declined 28 percent to $258 million.

Sales of irons decreased 30 percent to $51 million and represented 32 percent of sales.

Sales of steel irons increased 4 percent year-over-year as sales of Big Bertha irons offset lower X-14 Steelhead sales.

By the way, X-14 irons are completing the third year of their product lifecycle and have become our best-selling irons ever.

However, the growth in steel irons was more than offset by a considerable decline in the Hawk Eye VFT irons.

Keep in mind that we launched VFT irons a year ago, benefiting from sell-in numbers in the 2001 quarter.

In addition, these irons have a higher average sales price than our steel products.

Year-to-date iron sales increased 2 percent to $212 million.

Sales of putters, accessories, and other products increased 38 percent to $42 million.

The growth was driven by continued strength of our Odyssey 2-Ball putter and initial shipments of our new wedges.

Year-to-date sales of putters and accessories and other products are up 43 percent to $141 million.

Sales of golf balls for the quarter declined to $11 million from 12 million last year, but year-to-date, golf ball sales increased 29 percent to $58 million.

The quarterly decline can be attributed to a decline in rounds played this year, no new product launches, and the price reductions Ron already mentioned.

Turning to geographic sales trends, our U.S. sales decreased 22 percent to $80 million during the third quarter and international sales declined 14 percent to $80 million due to continued weakness in Japan and rest of Asia.

Sales by regions were as follows: Europe increased 11 percent to $31 million during the quarter and is up 15 percent year-to-date to $118 million.

In constant dollars, Europe was up 3 percent for the quarter and 13 percent year-to-date.

Japan declined 30 percent to $24 million and is down 28 percent year-to-date to $80 million.

In constant dollars Japan declined 31 percent for the quarter and 24 percent year-to-date.

The key factor in this year-over-year decline is lower Titanium Wood sales offset partially by double-digit growth in steel woods, putters, balls, and accessories.

Sales to rest of world declined 19 percent to $26 million during the quarter.

Year-to-date sales to rest of world declined 10 percent to $96 million, also primarily due to reduced Titanium wood sales.

Turning to the rest of the income statement, during the quarter we posted a $17 million warranty adjustment due to the fact that we refined our method for estimating potential claims as we reported in our conference call last quarter and in our September 26th press release.

This adjustment was the result of a comprehensive review of our warranty commitments, which indicated that claims occur earlier in the product's life than had been originally estimated and then tail off significantly with time.

As we mentioned in our press release, we intend to seek confirmation with regards to when we recognize this benefit.

Given the current business environment, we will, with our auditors, be informally contacting the SEC on this topic.

Now, continuing, we also recognized during the quarter a $3 million inventory obsolescence reserve for ERC II and Big Bertha C4 drivers.

Third quarter gross profit decreased 24 percent to $72 million and gross margins decreased to 45 percent of sales from 49 percent last year.

The gross margin decrease was primarily attributable to the decline in average sales price, which offset continued reductions in club manufacturing costs.

Year-to-date, gross profit declined 7 percent to $338 million, consistent with sales trends, and gross margin was unchanged versus last year at 51 percent of sales.

As Ron mentioned, the labor and overhead associated with manufacturing clubs is down 13 percent in 2002 at an average of 9 percent over the last three years, reflecting the many cost-cutting initiatives we've implemented.

Operating expenses for the quarter declined 4 percent to $68 million, or 43 percent of sales, from $71 million, or 36 percent of sales, last year.

Expense reduction initiatives and lower goodwill amortization resulted in the 25-percent decrease in G&A expenses and funded the 4-percent increase in selling expenses.

Year-to-date operating expenses declined 5 percent to $225 million, or 34 percent of sales.

Operating income during the third quarter declined to $4 million from $24 million and operating margin decreased to 2 percent from 12 percent last year.

The lower operating margin was directly attributable to the negative leverage associated with the lower level of sales.

Year-to-date operating income decreased 12 percent to $113 million, or 17 percent of sales compared to 18 percent of sales last year.

Third quarter net income decreased to $2 million with diluted earnings per share of 3 cents compared to net income of 14 million and 20 cents last year, and this was slightly above our recent guidance.

Year-to-date net income decreased 15 percent to $70 million, while EPS is $1.03 per share versus $1.12 last year.

Our golf ball business slowed during the third quarter.

Golf ball sales declined to $11 million from the 12 million last year, reflecting the more competitive environment and a decline in the number of rounds played.

Ball margins were negative single digits during Q3 compared to positive high teens last year, while year-to-date gross margins are positive and have improved to the low 20s compared to the mid-teens last year.

The decline in margins for the quarter was due to compensation for our price reduction, a charge related to the purchase of the ball equipment, and less manufacturing leverage due to lower sales and less inventory build than a year ago.

We have increased our marketing and advertising expenses for the golf ball in recent months to fight for market share.

As a result, 2002 year-to-date operating losses in our golf ball business are $17 million versus 14 million at this time in 2001.

Our financial position remains very strong, and we continue generating solid cash flow.

Our cash and marketable securities balance increased $12 million sequentially to $104 million after investing $11 million to repurchase shares during the quarter and another $51 million to buy out our golf ball equipment lease.

We also ended the quarter with nominal debt and $252 million of working capital.

Cash flow from operations year-to-date increased 34 percent to $127 million.

Net inventory decreased 8 percent year-over-year to $134 million and has declined 20 percent since the beginning of the year, consistent with our typical seasonal pattern.

Accounts receivable increased 6 percent year-over-year to $103 million and declined 41 percent sequentially.

This year-over-year increase reflects a trend we've had all year and is a direct result of our preferred retailer program we launched late last year.

The quality of our receivables has improved since last year, and past due accounts are down significantly compared to last year.

Capital expenditures during the third quarter were $56 million, which includes $51 million to buy out our golf ball equipment lease from GE.

Depreciation and amortization totaled $10 million.

Turning to our guidance, in light of the current market conditions, we reiterate our full-year sales guidance that we announced last month, expecting sales in the range of $750 to $760 million with fully diluted earnings per share of 85 to 90 cents.

We did come in at the high end of our late September guidance, and I'm sure many of you would like to add this upside to your full-year numbers.

However, given all of the economic and consumer factors Ron mentioned, it would be premature to do so at this time.

We are encouraged by the initial interest in our new products, including the GBB II, and if this level of interest holds there could be some upside to '02.

But, again, it's too early to count on this.

It is our intent to provide further guidance for '02 and '03 later this year.

I would now like to turn the call back over to Ron.

As we begin preparing for next year, we are most concerned about the U.S. economy, the banking crisis in Japan, and the threat of war with Iraq.

We have been introducing our new product line to accounts around the world since the beginning of September.

While we are enthusiastic about our 2003 products, and excitement is building among our retail partners, we remain cautious until we see solid indications that consumer confidence is improving and they reestablish increased spending patterns.

Obviously, we cannot control consumer spending.

What we can do is continue delivering demonstrably superior products, which I believe we have.

On the expense side of the equation, we are reviewing all aspects of our business to identify how we can improve our financial performance to dampen the impact of industry weakness on our earnings.

As Brad mentioned, until we have a better read on consumer spending trends, retailer reaction to our new product line, and implement additional expense management initiatives, we are unable to give you specific guidance for next year.

In closing, let me reiterate a few key points about Callaway Golf Company.

We recognize that our golf ball operations remain a challenge, and we are working diligently to eliminate the drag on earnings.

We are the proven industry leader in golf clubs with number-one market share in woods, irons, and putters.

We have considerable financial strength to support our brand and preserve, even gain market share.

We have a debt-free balance sheet and generate considerable free cash flow.

That concludes our prepared remarks.

I would like to thank you for participation in today's conference call and your continued interest in the company.

With that, we will now open the call for questions.

At this time I would like to remind everyone in order to ask a question, please press star then the number 1 on your telephone keypad.

We'll pause for just a moment to compile the Q&A roster.

Your first question comes from Carol Byers of RBC Capital Markets.

Hi, good afternoon.

Just a couple of questions - first of all, just with the timing of the GBB II this quarter - is it this quarter we only saw the effect in Europe and Asia, right?

And then in Q4 we're going to see the U.S.?

Carol, it was a very modest amount that found its way into the U.S. market but not significant.

Okay, so the timing that we'll see it will be in this quarter?

Yes.

Okay, and then did you guys say that the ball business for the quarter did negative single-digit gross margins?

Yes.

Okay.

Now, there were some extraordinary items in there, Carol.

I mean, you've got compensation for the price reduction, and we had a charge in there during the purchase of the golf ball equipment.

Could you say what do you think the golf ball business lost for the quarter?

And maybe net out what you consider to be, kind of, one-time in nature?

The one-timers would have put it in low single-digit positive, and I don't have the dollars right in front of me.

Single-digit positive gross margin?

It would have been positive gross margins excluding those one-timers.

Okay.

And then one more question, and then I'll open it up, but the timing of your detailed guidance - is it going to be in a formal conference call, or do we - and - around what time?

I think, Carol, we'll be talking around sometime prior to mid-December.

Okay.

And then I have actually one more question - when you were talking about the margins and the adjustments, you included in there the inventory write-down, correct?

Yes.

Yes.

Okay, and it's in the gross margin?

Yes.

So we can actually adjust that - that's only one time in nature as well?

Fair?

I think the amount this time is unusual, but obsolescence is an ongoing part of the business.

That's true.

Okay.

Thank you.

Your next question comes from Brett Hendrickson of B. Wiley and Company.

Hey, good afternoon, guys.

Hey, Brett.

Hey, Brett.

Let me see, actually - she brought up a question that I had on GBB II.

Are you still going to be holding back some in the United States in Q4?

Are you just very kind of regulating supply a little bit there?

Our plan with GBB II is to only service the market for what is selling through, not to load the channel.

Mm-hm.

And - okay - but it's not to purposely hold back and try to create, like, a Pro V1 kind of a hysteria or anything like that?

I don't understand what that would be.

You know, it's not available at retail so it creates a kind of word-of-mouth buzz, and then you actually get some benefit from that later.

No, we're planning on servicing the market in what it can take in this normal time of the year that consumers will buy.

We're trying to control our ramp up and production at the same time, Brett.

Makes sense.

And then internationally in Q3, it was fully available for a month or two of Q3?

Or how long?

It was about three weeks of September it was available.

Okay.

And then your preferred customer program, where they get the moderately longer terms, Brad, has that fully cycled?

Are you going to continually be adding customers to that?

Oh, you know what?

First of all, this is the first year, so it's an increase versus where we were last year.

I would say, going forward, as we refine the program, those who haven't participated or lived up to their end of the agreement, we would probably manage that out.

It will probably be flat year-over-year.

Okay, so there might be some shifting of retailers within it, but the number is flat?

Pretty stable.

Okay, and what's the longest terms that those guys get?

We don't comment about all the terms, Brett.

Okay, I'll talk to them.

And then last question -your press release is a little cryptic - the pre-announcement press release talking about - Ron, I think you were quoted as saying, "Taking any necessary actions" to get the golf ball to profitability.

Besides sheer headcount and cost reductions, can you give us a flavor for what other actions might be?

Well, I think what I actually said was we're going to look at all options, and that's what we're going to do.

Okay, so what would the other options be besides just old-fashioned cost reductions?

All options.

Every one I can think of, every one you can think of.

Okay.

All right.

Well, that's all I've got.

Thanks, guys.

Thanks, Brett.

The next question comes from Casey Alexander of Guilford Securities.

Hi, good afternoon.

Hi, Casey.

Hi, Casey.

Can you explain to me a little bit clearer what the deal was with buying out the golf ball equipment off of the lease from GE and what its financial impact might be going forward?

Can you give me a little color on that, please?

Well, what kind of color do you want?

We had an option to get out of the equipment.

Long term, you know, we were held to the lease, and we felt it was appropriate to buy the equipment at the price that we'd agreed to, and it gives us freedom to operate as we go forward and look at all options surrounding the golf ball business.

Okay.

Are you accelerating the share repurchase program with the stock down here in the 10s?

No, we think that with all of the options we're looking at regarding golf ball and with the exercise we're in the middle of, of looking at all of the expense-related items regarding golf club, there are enough moving parts out there that we are privy to, that we feel like we should be out of the market at this time.

Okay.

Is there - can you kind of outline your enhanced efforts to get your drive count going on tour?

Yes, we have - what we think is a really exciting product, and, hence, we have gone back to a very familiar name for golfers around the world, the most popular driver ever, was Great Big Bertha.

With that ammunition, we felt very comfortable that we would be able to penetrate all of the professional tours, and we have done that and, as you may or may not know, for players who are not on our professional staff, it's very common to pay a tee-up weekly stipend, especially on the PGA tour, to have people put the product in play, and we have done that in order to get the product in play with individuals that are not on our staff, the result being we've got a great win out of Perry this year.

The first time he's won in the United States, Craig Perry, an Australian, and, of course, we had Charles Howell break through, and Annika Sorenstam is out there talking about the driving distances she's getting with the product, but we are taking some aggressive actions to go back after the share that we once had on the professional tours with our premier product.

Okay, thank you.

Your next question comes from Joe Yarman of Bear Stearns.

Hey, guys.

Hey, Joe.

Hey, Joe.

To preempt a question that's likely to surface tomorrow, I want to talk a little bit about the inventories.

In light of the charge that you took, the $3 million to write-down, I guess, was a combination of the ERC and the C4, just a couple of questions.

One, could you speak to the quality of the inventory?

Two, can you talk about the percentage of finished goods as a percentage of total inventory?

And, Ron, I'd be interested to hear your thoughts about C4 and maybe some plans that you might have for repositioning that product going into '03.

Thanks.

Yeah, just to - Joe, the raw material, 55 million; work in process, 2; finished goods, 89.

Okay, and with regards to quality, we feel very good about the quality of the inventory.

As you know, we talked about this before, you know, every quarter we go through with a fine-tooth comb and look at all our inventories and either have programs in place with which we know we can liquidate them.

We manage them very tightly, and if we feel that there's a need to provide for it, which we did this quarter, why, we'll go ahead and increase the obsolescence.

So we feel pretty good about the inventory.

I'll let Ron answer the C4 question.

Joe, with regard to the C4, let me first say that while we have been the number-one market share leader in metal woods for a long, long time, we don't sit here and claim to have all the answers, and not every product is a homerun product.

When we brought C4, our intention was that we would position that product for slow swing speed players, and what happened was a couple of professionals got it into play, and we sort of changed our thinking about it.

Quite frankly, in hindsight, I think we were probably wrong and let our expectations get a little too high on C4.

We will continue with the product in the line next year.

It's a good product.

It doesn't appeal to everyone, as you well know because of the lack of an explosive sound that the golf club delivers, but it is a great performing product, and we'll continue it in the line, and as we introduce programs to our retailers, we'll have it positioned so that it goes after the segment that it was initially designed for.

All right, thanks, guys.

Your next question comes from Jonathan Yerdwick of Third Point Management.

Hi, guys.

Congratulations on a great quarter.

I just had a question for you on your gross margins real quickly - if I'm doing the math correctly here, and it counts for the $17 million warranty reserve, the blended gross margin is more like 45 percent versus 55 percent, is that correct?

Let me get my -

I guess my question is - I mean, you guys have done a lot of great initiatives in terms of outsourcing some of your club production to China, but why would there be such a great deterioration at the gross margin level?

Have we just seen a much larger decline in average selling prices of the clubs?

I mean, you've talked a lot about the deterioration of pricing being at the balls, but is it also largely at the driver level?

Well, what the gross margin line suffers from is mix.

The Titanium metal wood business is down.

All other product categories are up double digits.

Titanium metal woods carry the highest selling prices and the highest margins, and they're down naturally because of the second year of product production.

So there's a mix issue going along with the golf ball plant utilization issue.

Okay.

Thank you.

Your next question comes from Ellen Hennessey of Rice Bolger.

Hi.

I was wondering if you all could talk a little bit more about the preferred retailer program.

Just wondering if, after a year of learning about how it works and how your retailers like it, is there anything that you guys are going to change?

Yes, there are some things that are going to be changed, Ellen.

I'm not going to disclose them here but generally the program has been successful for us.

The accounts that participated in the program this year, by and large, had increased activity.

So we view it as a positive thing at this time, and there will be some modifications to the program to make it better.

Okay, but you can't give us any color on that?

No.

Okay.

One other question - September 27th, you guys gave us your guidance, and I'm just wondering what happened between that time and today and where the extra - it looks like it's about three pennies on operating - maybe three to four pennies.

But where did that come from?

What did you guys find in that timeframe?

Well - this is Brad - when we do the estimate, I mean, so much of it in this case, it's timing, and while we try to put together an estimate that we feel very, very comfortable with, as you can see, we came in at the high end of the range on sales, because sales picked up slightly those last couple of days, and then, lastly, some of the expenses that we had felt would hit in the third quarter, timing didn't happen, and it's an estimation process with all of our subsidiaries around the world.

So we were a little conservative and, I think, from a timing perspective, some of the expenses didn't roll into the third quarter will hit in the fourth quarter.

So it's really timing.

Okay, I gotcha, great.

Thanks.

At this time I would like to remind everyone in order to ask a question, please press start then the number 1 on your telephone keypad.

At this time there are no further questions.

I would just like to thank everyone for participating in today's call.

Thank you for your interest in the company.

I can assure you that we are going to work hard on the issues that we mentioned earlier to improve results as we go forward.

Thanks.

This concludes today's Callaway Golf conference.

You may now disconnect.