Callaway Golf Company — 2009 Amit J. Shah Frostburg State University ‘Who was the mast dominant player in women’s golf in the world through 2008-2009, and what clubs does she use? The answers are Annika Sorenstam and Callaway clubs. Callaway makes premium-priced golf clubs that are popular with both amateurs and pro- fessionals, as well as high-tech golf balls including the HX, CPU 30, and CBL. Callaway's drivers include the ERC Hl, Hawk Eye VFT, Steelhead, Big Bertha Titanium 454, FT-9, and the latest FTiQ Callaway recently developed Fusion Technology, which has led to the world’s smartest, most advanced driver: the new FT-iQ Driver. Through robot testing measuring hits across multiple face locations, the FAQ Driver is the longest driver Callaway Golf Company has ever made. It also licenses its corporate name for apparel, shoes, and other golf accessories. In June 2009, Callaway slashed its dividend. Since 1997, it had paid a constant $.28 per share annually, but, in order to conserve cash, it lowered the payout to just $.04. Also that month, the company used the proceeds of a $140 million convertible preferred stock sale to pay off its entire short-term debt. This move was quite embarassing to management, as Callaway had been acquiring shares from the time current CEO Fellows arrived in 2005 (with no debt on the balance sheet) through 2007. Callaway will report a loss for calendar 2009, with the cost of the preferred equit (6.09 pee share) as well as weak business trends contributing, Analysts do, however, fore- cast a strong recovery in 2010 and 2011. The bulk of Callaway’s sales come from golf ‘ibs, but even sales of golf balls declined more than 20 percent in 2009. Callaway histor ically has spent 5 percent of revenues on R&D but now spends only 3 percent. Callaway's management surprisingly does not own that much of the company’s stock, CEO Fellows owns just 1.2 percent and the entire top management team and the board hold just under 3 percent of the company’s outsianding stock. History Ii 1982, Ely Callaway founded Callaway Hickory Stich USA, Inc., which later became Callaway Golf Company (CGC). Although the company was incorperated in Califomia in 1982, it was reincorporaied in Delaware in 1999. CGC's products are designed and built on ameight-building campus in Carlsbad, California, where the majority cits 2,700 employees work (as of December 2008). Tn ity early years, Callaway sevolutioniaed th “very forgiving” and therefore very welcome Wo the average £0 production methods tumed the smallest golf club manufacturer into the world’s largest fraker of premium golf clubs and a dominant force in the industry. During the years of growth, Callaway acquired well-known brands like Oyssey, a manufacturer of putters, in 1997, Strata, a manufacturer of golf balls; and Ben Hogan, a competitor in golf clubs. In 2000, Callaway entered the golf ball kusiness with the release of its first golf ball. In 2004, the company acquired all of the issued and outstanding shares of stock of FrogTrader, Inc, (which subsequently changed its name to Callaway Golf Interactive, Inc.) dustry with golf clabs thal were fer, New technologies andCASE 28 + CALLAWAY GOLFCOMPANY —2009 273 The compuny sequired Frog Trader to stimulate purchases of new clubs by growing its ‘Trade In! Trade Up! program und to enable the compuny to better munuge the distribution of preowned golf clubs. In 2008, the company acquired certain assets and liabilities of uPlay, LLC, a developer and murketer of global positioning system (GPS) devices. The company acquired uPlay to expand its accessories business by adding satellite-based range finders and for the potential application for other products as well Callaway won the bidding war in 2003 for Top-Flite Golf, with a $174 million offer that ended a struggle with rival Adidas-Salomon, owner of Taylor Made Golf. Top-Fl leading manufacturer of golf balls and has a high reputation among professionals and recreational players. Top-Flite, the nation’s second-largest golf ball maker behind industry leader Titleist, had $250 million in 2002 golf ball sales. The company’s $530 mi ion in debt and the highly competitive market forced it into bankruptcy. Under the deal, Callaway assumed Top-Plite’s debt. Vision and Mission CGC does not have a vision statement published on its Web site, but it does have a mission statement, as follows: (Callaway Golf Company is driven to bea world class organization that designs. develop, makes ain! delivers demonstrably superier and pleasing different golf products that incorporate breakthrough technologies. backs those products with noticeably superior caxstomer service. and generates a return to the shareholders in excess of the cast of ‘capital. We share every golfer’s passion for the gamne, and commit our talents and our technology to increasing the sutisfaction and enjoyment all golfers derive from pursuing that passion, Current Operations CGC boosted its net income 1 $66 million in 2008 as indicated in Exhibit 1, ‘Despite the challenging und unfavorable globul economic conditions, CGC pasted 2008 ‘et sales of $1,117 billion, which was the second highest sules level in the company’s history and only slightly tess than the record sales of $1,125 billion in 2007, Callaway has also delivered u proforma camings per share of $1,04, un increase of approximutcly 6 percent, EXHISIT 1 Callaway Golf Company Five-Year Statement of Operations Year Ended December 31 2008 2007 2006 2005 2004 (in thousands, except per share data) Net sales $1,017,204 $124,591 $1,017,907 $998,093 $934.564 Cost of sales 630371 631.368 619,832 583,679 S7S.742 Gross profit 486,833 493,223 398,075 414d 358.822 Selling. general and administrative expenses 373.275 371,020 33235 370.219 382.967 Research und development expenses 20,370 32,020 26,785 26989 30587 Income (Loss) fiom operations 84,188 90,183 37,085 17.206 (24.702 Interest and other income, net 1,863 3455 3,364 (390) 1934 Interest expense (4,666) (5,363) (3421) (2279) (945) Unrealized energy derivative losses 19,922 _ _ _ _ Income (Ioss) before income xcs 101,307 88.275 34,998 14,537 (23,713) Income tax provision (benefit) 35.131 33,688 11.708 1253 (13.610) Net income 66,176 $4,587 23.200 13.284 Sewree: Callaway Goll Company. Asual Reporaitorm 10K Q008),274 AMIT). SHAH During the second half of 2008, the deteriorating economic conditions in the United States spread to most of the Callaway's international markets and resulted in an overall decrease in net sales for 2008 from 2007. In spite of the economic struggles, CGC's financial position remains strong because the company hus little kong- 12 presents the consolidated balance sheet of Callaway, liquidity, Exhi EXMIGIT 2 Callaway Golf Company Consolidated Balance Sheets (in thousands, and per share data) m debt and high December 31 2008 2007 ASSETS Current assets: Cash and cush equivalents 3 38,337 549,875 Accounts receivable. net 120.067 163.515 Inventories, net 257.191 Deferred Laxes 27,046, Income taxes receivable 15.549 9,232 Other current assets 31813 30.190 Total current assets 490,003 496,581 Property, plum and equipment, net 142,145 128,036 Intangible assets, net 146.945 140.985 Goodwill 29,744 32,060 Deferred taxes 6299 - Other assets 40.202 40.416 TOTAL $855,338 $838,078 LIABILITIES AND SHAREHOLDERS’ EQUITY Current tixbilities: Accounts payable and accrued expenses $126,167 5130410 Accrued employee compensation and benefits 25.630 44,245 Accrued warranty expense 11614 12,386 Credit Facilities 90,000 36,507 ‘Total currem hiabilities 253411 548 Long-term liabilities: Deferred taxes, net _ 2.307 Deferred compensation £566 8.200 Energy derivative valuation account _ 19,922 Income taxes payable 13,833 Commitments und contingencies (Note 15) ‘Shareholders’ equity: Preferred Stock, $.01 par value, 3.000.000 shares authorized, none issued and outstunding at December 31.2008 and 2007 + = Common Stock, $.01 par value, 240,000,000 shares authorized, 66,276,236 shares and 66,281,693 shares issued at December 31,2008 and 2007. respectively 663 663 Additionall paid-in capital 102,329 111,983 continuedCASE 28 + CALLAWAY GOLF COMPANY — 2009-275) EXHIBIT 2 Callaway Golf Company Consolidated Balance Sheets (in thousands, except sh: and per share data)—continued December 31 72008 2007 Unearned compensation (279) (2.158) Retained eurnings ‘S18851 470469 Accumulated other comprehensive income (6,376) 18,904 Less: Grantor Stock Trust held at market value, | 440570 shares: and 1,813,010 shares at December 31. 2008 and 2007. respectively (13,383) GL601L) Less: Common Stock held in treasury. at cost, 1,768,695 shares and 0 shares at December 31, 2008 and 2007, respectively (23,650) -_ ‘Total sharebolders' equil 578,155 568.230 $855,338 $838,078 Ssmurce: Callaway Golf Company, Amul Repurifonm £0K COUR) (CGC hus silso licensed its trademarks to IZZO Golf, TRG Accessories, LLC, Fossil, Inc, Nikon Vision Co., Lid., and Global Wireless Entertainment, Ine. Prior to April 2006, the company had a licensing arrungement with Tour Golf Group, inc. (TGG) for a line of Callaway Golf footwear. In April 2006, the company terminated the licensing arrangement and acquired certain assets of TGG. CGC recognized royalty income under its various licensing agreements of $8,847,000. $8.672.000, und $8,292,000 during 2008. 2007, und 2006, respectively. Callaway Products Exhibit 3 portrays Callaway's contribution of net sules by principal product group. CGC's salles of drivers and woods increased in 2007, duc to u more extensive line of drivers in 2007 relative to 2008. The decrease in new driver introductions contributed toa reduction in over- alll average selling prices within the woods category because drivers, particularly premium Fusion Technology drivers, carry a higher sales price than fairway woods and hybrids. Sales cof putters and irons in 2008 have also declined from 2007. However, sales of golf balls and accessories huve made significant increases from 2007. In 2007, overall sales increased from the previous year by more than $106 million; however, in 2008, sitles decreased from the previous yeur by $7.4 million, The company's drivers, fairway woods, irons, and golt bulls are sold under the Callaway Golf, Top-Flite, und Ben Hogan brands, The putters ure sold under the Odyssey. Callaway Golf, Ben Hogan, and Top-Flite brands. Golf Datutech reports that the number of golf rounds played in the United States declined by 4 percent between February 2008 and 2009. Acconding w Golf Datatech, the EXHIBIT 3 Contribution of Net Sales Attributable to Principal Product Groups Year Ended December 31 2008 2007 2006 Cinthousands) Drivers and fuirway woods $ 268 286 24% § 305,880 21% 3 266478 26% Irons 308,556 28% 309,594 28% 287,960 20% Putters 101,676 OF 109,068 10% 102,714 10% Golf balls 223,075 20% 213,064 19% 214,783 2% Accessories and other 215611 19% 186,985 16% 145,972 14% Net sales 117204 100% 124,591 100% 1,017,907 10% Scatrce: Callaway Golf Company. Rirm 10K 008),276 AMIT). SHAH EXMISIT 4 Sales Information by Region Year Ended December 31 2008 2007 Percent change 2006 Percent change Net sales: inthousands) United States $ 554,029 $ 597,569 “1% $§ 566,600 5% Europe 191 089 193,336 “1% 159,886 1% Japan 166,476 120,148 Oe 105,705 4% Rest of Asia 80,011 86,133 Te 75,569 4% Other foreign countries 125599 127,405, 1% 110,147 16% Total 1117204 1,124,591 1h 1,017,907 10% Source: Callaway Gill Company Form 10K (2008). regions with the strongest growth in number of rounds played include the West North Central, East North Central, and New England. In 2008, approximately 50 percent of the CGC’s net sules were generated within the United States, and 50 percent were generated elsewhere. The company does business in more than 100 countries around the world. The majority of the company’s international siules are made through its wholly owned subsidiaries located in Europe, Japan, Canada, Korea. and Australia, Exhibit 4 provides sales information for CGC based on international regions. From 2006 to. 2007, no region incurred a loss in sales; however, between 2007 and 2008, three regions incurred losses, which were Europe (1 percent loss), the rest of Asia (7 percent loss), and ather foreign countries (I percent loss), Business Ethics and Environmental Matters CGC adopted a corporate Code of Conduct and Ethics Policy in 1997 applicable to all employces and directors, including senior financial officers. CGC previgusly permitted Jouns to employees, including executive officers, in restricted amounts (up to $150,000) ‘and for limited purposes (purchase of a primary residence), There are currently no oulstunding Louns o executive officers under this program and only two loans outstanding w nonexecutive alficers. CEO/CFO certification procedures pursuant to Section 302 of Sarbanes-Oxley, established in November 2002, have been implemented at CGC. The company also has an insider wading policy that is written, distributed to all employees. and accompanied by training. Officers and key employees are subject to “gatekeeper” review and approval by the CGC’s legal department. CGC operations are subject to federal, state, and local environmental laws. During the onfinary course of its manufacturing process, CGC creates toxic waste through the use of special maleriuls und production processes. The waste is regularly iransported off site by registered waste huulers, As a standurd provedure, a comprehensive audit of the treat- men|, storage. and disposal facilities with which the company contracts for the disposal of huzardous waste are performed annuully by CGC. The company employs two full-time environmental engincers at its Carlsbud, California, facility and a director of environmen lal, health, and safety matters at its Chicopee, Massuchusets, facility to manage the program. Itis also a charter member of the U.S. Environmental Protection Agency's National Performance Track program, which recognizes facilities that have demonstrated a commitment lo superior environmental performance und compliance. Business Operations CGC has subsidiaries all over the world; those wholly owned by CGC include Callaway Golf Sales Company, Callaway Golf Ball Operations, Ine. (formerly known as The Top- Rite Golf Company), Callaway Golf Interactive. Inc.. Callaway Golf Europe Ltd... Callaway Golf K.K.. Callaway Golf Korea Lid., Callaway Golf Canada Lid. Callaway Golf SouthCASE 28 + CALLAWAY GOLF COMPANY — 2009277 Pacific PTY Ltd, Callaway Golf (Shanghai) Trading Company, Lid, Callaway Golf Malaysia Sdn. Bhd. (formerly known as Titanium Winners Sdn. Bhd.), and Callaway Golf Thailand) Lid. CGC distributes directly to the retailers ar to the wholly owned subsidiaries und third-party distributors. The company also licenses its trademarks and service marks to third purties in exchange for myalty fees. Exhibit 5 presents CGC’s organizational chart Manufacturing golf clubs is primarily done at CGC's facilities in Carlsbad, Culifornia, Some of the products are assembled outside the United States. Assembly of the dlubs is done using components from suppliers from both within and outside the United States. The golf club assembly process is “very labor intensiv Prior 10 the Top-Flite acquisition, CGC manufactured its golf balls in its Carlsbad, California, facility, and Top-Flite manufactured their golf halls primarily in its Chicopee, Massachusetts, and Gloversville, New York, facilities. Since the acquisition, however, the compuny hus moved the majority of its golf ball manufacturing to the Chicopee and Gloversville facilities und is in the process of moving the remainder to those facilities aver the course of this year. The golf ball manufacturing process is “much more automated” than the golf club assembly process, although, the company points out, much labor is still used in the golf ball manufacwring process. ‘The golf business is highly seasonal. In the busy summer season, CGC employees are required 10 work many hours of overtime, whereas in the winter. production capacity is only about 68 percent. These special conditions require a special employment contract based om u Working-hours uecount, which allows employees to use overtime work hours, guthered during high production, to make up the unused work time in the off season, As of year-end 2008, CGC und its subsidiaries employed 2,700 employees full time and part time, CGC employees “historically have not been represented by unions.” according to the company's annual report, ‘The manufacturing employees ut the Top-Flite plant are represented by & union. CGC hud upproximately 480 employees covered under a collective bargaining agree ment, as of December 31, 2008, Callaway has renegotiated a new collective bargaining ‘agreement with the union in Chicopee. which is scheduled to expire on September 30,2011 The production employees in Canada and Australia are also unionized. According to CGC, the company “considers its employee relations to be good.” EXHIBIT 5 Calloway Organizational Chart Samuel H Armacost*; John Cushman, |lI* Yotaro Kobayashi*; Richard L Rosenfield; 5. Thomley*; John F. Lundgren* Mndicales independent statuson board ‘Nominating & A Magent: Corporate Seccesion Governance Davi A. Laverty fee See adiey), Holiday Thomas Yang ‘Seen VP, Gherasenrianicice | | Sette Exeastive vt “senior VP, Oper one (Ohiet Financial OFtices merrationalAMIT J. SHAH Marketing Rupid introduction of new golf clubs or golf balls could result in closcouts of existing inventories at both wholesale and retul levels, Closeouts resull in reduced mirgins om the sale of older products us well as reduced wales of new products, (CGC announced 4 contract renewal with the number-two golfer the world, Phil Mickelson, in early 2009, Callaway also uses point-of-purchise displays for its products in golf shops and retail stores worldwide. Callaway has seen tremendous success under the Tride In! Trade Up! Program (wwwtrdeintradeup.com). Under this agreement, Callaway consumers can receive trade-in allowances on their previously owned Callaway golf clubs toward the purchase of new Callaway clubs. This option has become popular for consumers looking to upgrade their ‘equipment. It also provides a convenient aveauc for consumers looking to purchase cheaper used clubs. This program certainly helps Callaway build and strengthen customer boyalty. Callaway bas long been known for its commitment to innovation in its technology. (CGC’s tradition is built on product leadership and “the proof isin the more than 1,1 00United States patents—more thun any other golf manufacturer.” CGC has recently Inunched the Gillaway Golf FT frons. According t© CGC’s Web site, FT irons ure “the evolution of Fusion ‘Technology. delivering the utmost in performunce and playubility in Caltaway Golf irons for mid to low handicap players who demand the latest innovation with proven results” Since the introduction of the FT Irons. Calliway has introduced the FT ixbrid irons. These ituns are CGC’s most technologically advanced game-improvement set. The FT i-brid irons provide the ultimate in forgiveness and playability by incorporating three hybrid-like clubs designed to replace hard-to-hit long irony and gumesimprovement short imons. Callaway bus introduced 4 men's und women’s version of the FTIQ—the smartest, struightest driver the company has ever murketed and sold. The chub is availuble with fea- tures tht are accommodating to all golfers, with available loftsof 9, 10, and 11 degrees. as well us a High Trajectory [HT] model that offers 13 degrees. These higher degrees of loft muke getting the ball airborne easier on the player. The advanced head shupe hus a sleek book und increases the moment of inertia (MOD for extraordinary accuracy off the tee, For feel und performance, the FT-Q driver has an exclusive Fubuki shaft from Mitsubishi Rayon, tn advenising, CGC relies mainly on a combination of printed and television adver- lisements, Advertisements in print include national magazines, such as Golf Magazine, Sports Iltustrated, and Golf Digest, and \elevision commercials included primurily on The Golf Channel, ESPN, and on network television during golf telecasts. CGC also employs Web-based advertising. Outside of the United States, advertising is generully hundled by (CGC’s subsidiaries, and although it is based on its global brand principles, the local execu- tion is tailored by each region based on their unique consumer market and lifestyles. External Factors The current economic recession has decreased the level of demand for the company’s products, which are recreational and therefore discretionary purchases for consumers. Any decrease in consumer confidence. adverse economic conditions, or political unrest diverts interest from playing golf and hurts Calluway’s business. Individuals are more willing to rmuke such purchases during favorable economic conditions and when they are feeling con- fident and prosperous. Adverse economic conditions have caused consumers (o forgo or to postpone purchasing new golf products, The severe economic downturn may ulso affect GC's bad debt. which hus been historicully low. Natural disasters. sueb as the hurricanes in Florida and along the East Coast, cun negatively affect golf rounds played not only during the storms but ulso-for a significant period of time afterward while golfers focus.on leaning up rather thun playing golf. Golf is net a growth industry, There are approximately 26 million recreational players in the United States, but on average 3 million customers enter and 3 million customers exit the industry annually. ‘The met effect is zero growth. According to the Nulionul Sporting Gols Association's 2008 survey, golf's player pool shrank 7.3 percent from 2003 10 2007. The hitest repert from the National Golf Foundation shows rounds played ure downCASE 28 © CALLAWAY GOLFCOMPANY — 2009 27 35 percent for the first quarter of 2008. Also, it kes a lot of Lime to play golf, People today have so many other way’ to spend their Lime. A positive trend for CGC, however, is that the world's population is aging. and many older peuple beth play golf and have discretionary income to purchase golf equipment. Golf courses are averbuilt in the United States; the nurnber of rounds played was down 4 perwent in the United States in 2008 from 2007. More and more companies ure chasing the sume customers, which means that a gain in market share for one is a loss for another. For CGC to grow ils sales of golf clubs or golf balls significuntly. the company must cither increase its share of the market for galf clubs or balls, ar the market for these items itself must grow. Because CGC already possesses a substantial shure of the market in sules of clubs and balls, additional market share may be limited. In addition, the company does fot believe there will be any material increase in the number of golfers worldwide in the next four years. Competitors The business of golf has grown to become u billion-dollar industry worldwide, but due to the economic downturn, small companies may fall and big companies need to right- size und reset their business to survive. industry leaders spend millions an endorsement contracts for the game's best players to entice recreational players. For example, Nike pays Tiger Woods to use and endorse its products. A popular bul expensive way to gain market share is using PGA Tour players to promote your product. “The PGA Tour is the one bright spot in the whole industry,” suys Drapewu. “The TV ratings ure up: the attendance is up, A large purt of that is due to Tiger Woods.” Woods is se popular that Nike signed him to an endorsement contract sind then over time built an entire golf divi- sion around him, Woods once played Titleist equipment, but he shifted to Nike, Each lume he changed, he said he would not have changed unless Nike made the bes! product for him to play. Titleist is one of CGC’s biggest competitors. A subsidiary of Fortune Brands, Inc., Acushnet Company, owns the brand Titleist, among other brands. Titleist manufactures various types of golf clubs, as well as balls, equipment, and accessories. Other golf-related Acushnet brand names include FootJoy. Cobra, und Pinnacle. Acushnet primarily sells its products to on-course golf pro shops and select offcourse golf specialty and sporting goods stores throughout the United States, International distributors and agents sell the Products throughout the global market, including the United Kingdom, Canada, Germany, Austriu, Denmark. Ireland, France, Sweden, the Netherlands, South Africa, Thuiland, Singapore, Malaysia, Austrulia, New Zeulund, Korea. and Japan, Acushnet attributes ubout 42 percent of its sales to its international markets. The company is very strong in the golf shoe and golf glove markets (FoaUoy) and is the leading producer in golf balls (Titest) Between 2007 and 2008, net sules for golf-related operations at Fortune decreased from ‘$1.405.4 million to $1,368.9 million. This is attributed to the unfavoruble global economic conditions. Callaway competes with Acushnet in all three of its main markets: shoes und gloves, clubs, and balls More and more well-known athletic goods manufacturers such as Nike, Wilson, and Adidas, just to mention a few, are diversifying und expanding into the market. These com- panics have very good reputations, which helps them enter the golf equipment and avces- sories murket, Several compunies that produce high-quality tennis racquets, such ws Prince, Fila, Heud, and Wilson, are becoming a big threat to Callaway Golf, Wilson already does a substantial golf business, CGC's biggest domestic competition with respect to metal woods and irons are TaylorMade, Titleist, Cobra, Cleveland (Srixon), Ping. Mizuno, Bridgestone, and Nike. For putters, Callaway"s major competitors are Ping, Tilleist, and TaylorMade. CGC com- petes with Dunlop and Yamaha among others in Japan and throughout Asia. Mizuno is Japan's largest sporting goods maker and has made strides in the golf equipment industry. In the golf ball business, CGC faces competition from Titleist, Nike, Spalding, Surnitemo Rubber Industry. and Bridgestone (Precept). Titleist has un estimated market share in excess of 50 percent and is therefore ieading in the golf ball indusiry, In 2008, CGC was y4:3