Callaway Golf Company (CALY) Q3 2012 Earnings Report, Transcript and Summary

Good afternoon. My name is Allie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Callaway Golf Company Third Quarter 2012 Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to your host Brad Holiday, Chief Financial Officer. Sir, you may begin your conference.

Thanks, Allie. I'd like to welcome everyone to Callaway Golf Company's third quarter 2012 earnings conference call. Joining me today is Chip Brewer, our President and CEO. During today's conference call, Chip will provide some opening remarks and I will provide an overview of the company's financial results for the quarter, and we will then open the call for questions. I would like to point out that any comments made about future performance, events, prospects or circumstances, including statements relating to estimated sales, gross margins, operating expenses and loss per share for 2012, the estimated amount or timing of benefits and charges associated with the cost-reduction initiatives, the collectibility of our accounts receivable, as well as the company's estimated capital expenditures and depreciation and amortization expenses, are forward-looking statements subject to Safe Harbor protection under federal securities laws. Such statements reflect our best judgment today based on current trends and conditions. Actual results could differ materially from those projected in the forward-looking statements as a result of delays, difficulties or increased costs in implementing the cost-reduction initiatives or as a result of certain risks and uncertainties applicable to the company and its business. For details concerning these and other risks and uncertainties, you should consult our earnings release issued today, as well as Part 1 Item 1A, of our Form 10-K for the year ended December 31, 2011, filed with the SEC, together with the company's other reports subsequently filed with the SEC from time to time. In addition, during the call, in order to assist interested parties with period-over-period comparisons on a consistent and comparable basis, we will provide certain pro forma information as to the company's performance, excluding charges associated with the company's Global Operations Strategy, noncash tax adjustments, including a deferred tax valuation allowance, restructuring charges, the gain on the sale of 3 buildings, the gain on the sale of the Top-Flite and Ben Hogan brands, noncash impairment charges and charges related to the company's cost-reduction initiatives. We will also provide information on the company's sales on a constant currency basis and earnings, excluding interests, taxes, depreciation and amortization expenses and the asset impairment charges. This pro forma information may include non-GAAP financial measures within the meaning of Regulation G. The information provided on the call today and the earnings release we issued today include a reconciliation of such non-GAAP financial measures to the most directly comparable financial measures prepared in accordance with GAAP. The earnings release is available on the Investor Relations section of the company's website at www.callawaygolf.com. I would now like to turn the call over to Chip.

Thanks, Brad. Good afternoon, everybody. I'm glad to be with you today and have the opportunity to discuss our results, as well as the many changes happening here at Callaway Golf. The quick summary is as follows: first of all, our Q3 operating result fell generally within the expectations we provided at the end of Q2. Secondly, our outlook for the balance of the year has softened based on lower expectations in the U.S. and Europe, and thus, we are lowering guidance for the balance of 2012. And lastly, and I believe most importantly, we are making good progress on our turnaround plan, which I believe -- where I believe we are moving quickly, decisively and are on the right path. Looking at our operating results. In Japan, we have seen improved results versus last year based both on the launch of the Legacy '12 product, as well as improved market conditions versus last year. Our Japan business continues to be a strength for Callaway. Our primary areas of weakness in Q3 and for the balance of the year were in the Americas, Canada and the U.S., and in Europe. With the exception of our Asia-specific models, our 2012 products have not sold through well enough, and thus, during the quarter, we took aggressive pricing action to drive sell-through at lower inventory levels, both our inventory levels and those in the field. These actions had predictable results on our gross margins, but were successful in delivering the desired results in the field where we have enjoyed 5 consecutive months of hard good dollar market share growth in the U.S.. Although painful on a financial basis, right now, these actions are helpful for the long-term outlook in that they clear the channel and start to improve momentum for our 2013 story when we will have new product and new marketing to drive improved results. This is also significant in that to turn this business around, it needs to first stop shrinking, which means we need to stabilize and grow our dollar market share. To this end, in August, we had the first year-over-year gain in market share since November of 2010. During the quarter, we also began to show our 2013 product line to key partners and the feedback has been positive. Our larger customers are nearly uniformly behind us, they noticed the changes and improvements, and believe we will do better than recent offerings. That sentiment,I whole-heartedly agree with. Having said this, customers are also cautious given our sell-through track record in the last several years and are also excited about some competitive offerings. Net-net, I feel positive and I invite you to do your own channel checks to confirm and to best put this all into perspective. During the quarter, we also continued to firm up our 2013 marketing plans. As previously mentioned, these will be different, a.k.a. better, than recent years, and I look forward to rolling these out and showing them to you in January. On the tour front, we've continued to make good progress and I've received verbal agreements from several targeted players. At this point, I'm optimistic that our tour staff will also be improved for 2013, and I believe this, too, is a key item on our long-term turnaround list. For the balance of 2012, we have rolled back our guidance due to lower expectations for Europe, which is primarily economic based and for the U.S. and Canada, where we're going to have to continue to be aggressive in our promotional activity in order to drive sales of our existing products. In the U.S. and Europe, we did not have significant product launches scheduled for the balance of this year, which puts us at a comparable disadvantage to last year, when we've launched the RAZR XF Irons globally in Q4. In Japan, the Legacy '12 product launch, spread between Q3 and Q4, provided them with a stronger hand to play during the second half of this year. Now moving to our turnaround plan. Looking at our business overall, we have a great brand, a global presence and strong resources. However, it's clear that we're suffering from declining market share in our core business and a cost structure that is too high given that reality. We also believe the business has become distracted by competing priorities and brands and has been ineffective in several of those key initiatives. As a result, over the last 8 months, we've taken several decisive actions, including refocusing on our core business of clubs and balls where earlier on the year, we sold the Top-Flite and Ben Hogan brands, as well as licensing the apparel and footwear businesses. We've lowered our cost structure. In July, we announced a $52 million cost-reduction initiative and we are now furthering that to $60 million. We have taken action to stabilize our market share and clear inventories both here and the field; we are aggressively overhauling our product strategy and execution; we have changed our marketing approach and strategy, including bringing in new senior leadership; and we are building a more effective supply chain to improve cost, product development and customer service, again, including bringing in a new senior leadership. Most importantly, we're reenergizing our culture and rebuilding morale. This is an ongoing change effort which I'm happy to report is progressing well. People see substantive change, although some of the changes are difficult, I believe the vast majority agree with them and are energized by the clear new direction. Furthering this turnaround plan, during Q3, we've continued all of the above, including substantial progress in the product marketing and organizational change fronts, and made further progress on our cost-reduction and focusing efforts via strengthening our capital structure and lowering our cost of capital by issuing a new 3.75% debt instrument to replace the majority of our 7.5% preferred equity. This transaction was immediately accretive and Brad will discuss it in more detail during his comments. We reached preliminary terms from the sale/leaseback of our Chicopee, Mass golf ball facility. This transaction should close by the end of the year and result in smaller footprint in that facility roughly reducing our space up there from 810,000 square feet to 230,000 square feet. There is a $7.9 million noncash charge associated with this action, but it should provide significant cost savings and strategic flexibility for us going forward. We also restructured and streamlined our GPS electronic business to a third-party-based model. This action resulted in a $16.5 million noncash charge on the quarter but will allow us to improve profitability and focus going forward. We will continue to sell our existing electronic devices, but new products will be developed via partnership model. In addition, there were several other efforts aimed at streamlining and improving the efficiency of our business, which we're not going to go through with you today, but some of these additional moves increased our cost savings from the $52 million we announced previously to $60 million now on an annualized basis. The result of all of this is the much leaner, stronger and more focused Callaway Golf. We are going through a significant transformation, taking decisive actions and moving at a rapid pace. As a result, I believe that in 2013, we will be a more competitive and relevant player in our chosen space. Unfortunately, turnarounds such as this take time, however, I remain confident that the clear and specific actions we are taking will in fact turn this business around. I look forward to continuing to keep you updated on our progress and appreciate your interest and support. Brad, over to you.

Thanks, Chip. We have a lot to cover today. I will first review some of the larger actions that took place during the quarter, and then I will provide a quick overview of the third quarter results and an update our annual guidance. Because of the significant charges associated with our cost reduction and business streamlining initiatives, our supporting financials include GAAP results as well as supplemental details on these and other charges to bridge you to our pro forma or non-GAAP results. Additionally, to assist you in understanding the impact of the actions we've taken this year in streamlining our business, we've provided an additional schedule summarizing 2011 and 2012 quarterly sales and gross margins for our continuing core business and those we've either sold or are transitioning to a third-party model. I would encourage you to review the schedule as you develop your 2013 financial models. Before I review the financial results, I would like to provide some additional detail on the key initiatives that happened during the third quarter that Chip mentioned in his opening remarks. In August, we completed a convertible debt issuance of $112.5 million of 3.75% convertible senior notes due in 2019. $63 million of this new convertible debt was exchanged for 632,000 shares of the company's outstanding preferred stock; $49 million was issued for cash, of which netted to $43 million after discounts and fees; $35 million of preferred stock was converted to 5.9 million shares of common stock. The annual impact of this transaction will be an increase in pre-tax interest expense of $5 million and a reduction in after-tax net dividend of $7.1 million. This transaction was $0.02 accretive for the quarter and is estimated to be $0.05 accretive for the year. $42 million of preferred stock remains outstanding at this time and is redeemable at our discretion. With regards to the remaining net cash raise of $43 million, we will evaluate all potential opportunities that might arise, including the redemption of the remaining preferred stock and determine its most effective use. For now, we have used the proceeds to pay down our credit facility to a 0 balance. Also during the quarter, we had entered into an agreement in principle for the sale and leaseback of the Chicopee, Massachusetts golf ball facility. Due to a change in golf ball sourcing strategy, as well as streamlining and efficiency initiatives at this facility over the past several years, we are currently utilizing less than 30% of the facility footprint. Under this arrangement, we will sell the facility and surrounding property and leaseback only that stage required for our current operations. This decision resulted in a noncash charge of approximately $8 million in the quarter, which was included in our estimate of charges we provided last quarter. We estimate annual savings of just under $1 million and look forward to closing this transaction by the end of the year. Also during the quarter, we made a decision to restructure and streamline our GPS electronics business to a third-party-based model, where an outside partner will design, develop and sell new products under the Callaway Golf brand. We will continue to sell and service our existing products that are in the marketplace at this time. This decision further simplifies our business and allows us to focus on our core brands of Callaway Golf and Odyssey and key products of clubs and balls. This decision resulted in a one-time noncash charge of $16 million in the quarter associated with the write-down of assets associated with the original uPlay acquisition, as well as other related assets. We are increasing our estimate of charges associated with these and previous initiatives from a range of $36 million to $42 million to approximately $55 million, 2/3 of which is noncash. A majority of this increase is associated with the GPS decision. We increased our cost savings estimates from $52 million to $60 million due to these additional actions, with slightly more than 1/2 of the increase generated from the change in the GPS business model and the balance coming from additional streamlining and efficiencies gains. The new estimate positively impacts OpEx by $41 million annually with a balance of $19 million affecting cost to goods sold. Of the total $60 million, $18 million will impact this year, 2012, with an additional $42 million impacting 2013. Now let me quickly review some of the results for the quarter and year-to-date. All of the detailed financials are attached to our press release issued today, but let me add a couple of comments on the operating results. These results will be on a pro forma basis and in 2012, exclude the impact of the sales of the Top-Flite and Ben Hogan brands, the recent cost-reduction initiatives, including those during this past quarter and deferred tax valuation allowance. 2011 results exclude charges for our Global Operations Strategy, the noncash tax adjustments related to our deferred tax valuation allowance, the Top-Flite impairment, the gain on the sale of buildings and the 2011 restructuring initiatives. For the third quarter, sales totaled $148 million, in line with our internal expectations, but a decrease of 15% compared to last year driven primarily by the sale of the Top-Flite and Hogan business, as well as the weakness in Europe, Canada and the U.S. markets. 39% of the quarterly sales were from the U.S., with 61% from our international markets. On a year-to-date basis, consolidated sales were $714 million, a decrease of 3% compared to last year due primarily to the sale of the Top-Flite and Hogan business. Our core business is essentially flat compared to last year. U.S. accounted for 49% of the total, with 51% coming from our international markets. Foreign currency rates adversely impacted year-to-date sales by $4 million. Pro forma gross margins were 21% for the quarter, consistent with our internal expectations and were less than last year due to the increased promotional activity during the quarter. As Chip mentioned, while this promotional activity negatively impacted our gross margins, they were successful in delivering increased sell-through as demonstrated by the 5 months of consecutive U.S. market share increases in hard goods. On a year-to-date basis, pro forma gross margins were 37% compared to 40% last year, due once again to the increase in promotional activity, as well as higher cost on our more technical products, such as the RAZR Fit Driver, as well as the increased closeout pricing on our older putter models in preparation for the Metal-X launch last quarter. Pro forma operating expenses were $79 million for the quarter and were favorable compared to $85 million last year due primarily to our cost-reduction initiatives, partially offset by planned increases in marketing and advertising expense. Year-to-date operating expenses totaled $279 million, a decrease of 5% compared to $294 million last year for the same reason just mentioned. Turning to our balance sheet, we ended the quarter with cash of $59 million compared to $64 million last year. Our consolidated net receivables were $144 million compared to $148 million last year. DSOs were 89 days, an increase compared to 78 days last year due to increased promotional activities. The overall quality of our accounts receivables remains good. Net inventories were $189 million, a decrease of 7% compared to last year due to lower Top-Flite apparel and footwear inventories associated with our streamlining initiatives. As a percent of trailing 12-month sales, 2012 inventory improved to 22% compared to 23% last year. We ended the quarter with no outstanding balance on our credit facility, and at the end of the quarter, we had $82 million of available credit. Capital expenditures for the quarter were $2 million and we estimate full year CapEx to be approximately $20 million. Depreciation and amortization expense was $8 million for the quarter, and we estimate full year at $35 million. This excludes any accelerated depreciation that was included as part of impairment charges associated with the cost-reduction and business streamlining initiatives. While third quarter results were in line with our internal expectations, we are lowering our full year guidance because of our outlook for the balance of the year has softened based on continued economic weakness in Europe and continued aggressive promotional activity in the U.S. to drive the sell-through of our existing products in preparation for 2013. We now estimate net sales will range from $830 million to $845 million or the low end of our previous range of sales compared to $887 million last year. This year-over-year decline in sales is due primarily to the sale of the Top-Flite and Ben Hogan brands. As I mentioned earlier, we have provided the schedule summarizing 2011 and 2012 sales and gross margins by quarter, where what we would consider as now our core business, as well as those businesses affected by our streamlining initiatives. We estimate annual sales for our core business will be approximately $785 million for 2012, a good base to start with as you develop your 2013 model. Full year 2012 gross margins are estimated at approximately 35% compared to 38% last year due to the increase in promotional activity this year and adverse manufacturing absorption related to the decline in sales. Full year 2012 pro forma operating expense is estimated at approximately $363 million, which includes $18 million in operating expense savings this year. We estimate a diluted loss per share ranging from $0.73 to $0.83 on a share count of $67 million shares. We will now open the call for questions.

[Operator Instructions] And your first question comes from Andrew Burns with D. A. Davidson.

[indiscernible] on for Andrew. Just a quick question. You previously spoke about accelerating your season-end inventory cleanups to minimize depleting inventory. Can you speak a little bit to the success of those efforts and kind of how clean you feel your inventories are ahead of next season?

Sure. That has been a part of our actions we've taken over the last few months, and I'm pleased with the results. The product has sold through well as evidenced by our market share gains, and we anticipate that field inventories, as well as our own inventories, are going to be in good shape by the end of the year.

Your next question comes from James Hardiman with Longbow Research.

This is Phil Anderson, in for James. Just the market share numbers that you gave -- or I'm sorry, the market share trends that you gave, are those looking at global market share, or is that just U.S.-based?

U.S. hard goods dollar share. So just to simplify the issue, what I was referring to in my comments were U.S. hard goods dollar share.

And what do you guys include in hard goods?

Words, irons, putters, wedges, which is part of irons, golf balls, and I think that's it.

Okay. And then just looking at the year-over-year increase in market share that you said you posted in August, is that -- I guess how much of a function of the discounting that you've done do you think that is? And are there other strategic things you're doing that played a role in getting there? Or I guess just elaborate on that if you could a little bit.

Sure. Without question, the promotional activity we've done is the key contributor to some of the improved market share results. But there have also been small, but hopefully significant changes in our marketing and the address in this, which when you go to market, go through our sales execution and conducting our business. So it's impossible to factor or proportion what drove what percentage of that. I will tell you, I'm really pleased with the reaction to the moves we've made, and I think it's a good sign of brand strength in terms of the effectiveness of our moves thus far in the field.

And last question, do you know, were those market share gain sustained in September or is that data available yet?

It's not available yet. It's just starting to crease in, so we'll have to wait to give you that. But it isn't just 1 month that we're talking about, we've had several consecutive months, and there will be ebb and flow. We're not going to be able to fully deliver results indicative of how we're running this business until next year when we get fresh products and fresh marketing, but you are seeing some positive trends out there than more than just one month. The one month was the culmination where I was so pleased that we did show year-over-year, not just month-over-month improvement.

Right. You said 5 consecutive months of sequential gains? Was that the...

Five consecutive months of month-over-month gains. And then, August, we had a year-over-year gain, which is our first since November 2010.

And your next question comes from Ed Timmons with Roth capital.

I guess the first question I have is, what has changed -- in terms of the guidance that you're revising, what's changed since the previous update? I mean, things have been weak in Europe for quite a while now, you've had some product issues for quite some time as well. I'm just wondering, what's change in the last 3 months to cause the revision down again?

Well, we've had further -- this is not intended to be a short answer, but we further revised down our expectations for the business in Europe, which we do believe is strictly related to the economic conditions over there. So as our information came more clearly to us, we were forced to revise that. And although we certainly understood the situation in the U.S. and that we we're going to have to take promotional activity and such hasn't delivered the same level of revenue that we expected it to. And that culminated in us taking it down.

With the new product launches in '13, do you expect increased visibility? And should the -- let's call it limited visibility, continue at some point? Do you consider suspending giving guidance?

We think that, that the business benefit -- I think, at this point, that the business benefits from providing guidance. And when you're in a turnaround position and making as many changes as we're doing right now, having some level of limited visibility is par for the course. As we get further into our turnaround plan, as we deliver the changes in terms of product and marketing and demand creation that we have underway, we do envision improved visibility. Having said that, this has always been and always will be a difficult business to forecast. It's consumer discretionary with a technology and fashion element to it. So you put the product out and you need to excite the consumer and you're estimating that. But I have a good amount experience here as do we, and although we've had to revise this full year guidance numbers now, we're not anticipating that to be a trend.

Okay. And then switching gears a little bit on the endorsement side, you talked about having verbal agreements with a number of players, and I know you don't want to disclose names, but can you talk about the types of players or these younger players, are they previous winners on the tour? Any color around that?

Yes. And I can't talk much, but they are both domestic and international and they do include younger players and previous winners on tour.

Any comments on the rumors/talk on Rory's deal with Nike and how might that impact you guys, if at all?

No comment. Interesting rumors, fun to listen to.

Your next question comes from Lee Giordano with Imperial Capital.

I was wondering if you'd talk a little bit more about performance by category. It looks like woods were down 25% in the quarter. Was there anything year-over-year in terms of launch schedule that impacted that? Or it is still just promotionally driven decline?

Yes. I don't recall that there's anything that swung it on a year-over-year basis, so that was simply sell-through based and the actions we had to take to address that sell-through.

Got you. And when you think...

A little more color on there. We're stronger in the driver category than the Fairway Wood category and the hybrid category has been weaker for us this year. There's been some competitive success in those latter 2 categories.

And we've had some growth in the putter category with the launch of our Metal-X line of putters. So that was positive for the quarter for us.

Great. And can you talk a little bit about the HEX golf balls? Are you gaining share in that category, and how happy are you with the performance with the HEX?

It's a great golf ball and we're really pleased with the reaction to that product. You've seen us in a transition year when we're in the process of selling Top-Flite and divesting that business, grow our premium ball share, there's more and more talk about what a great product we have. We're in the process of streamlining our operating environment for the golf ball and we have -- we're optimistic for operating that business going forward.

Your next question comes from Craig Kennison with Robert W. Baird. Craig R. Kennison - Robert W. Baird & Co. Incorporated, Research Division: Many have been asked already, but maybe I'll just ask again, as you look at the future and many of your sort of financial and other targets, what would you have the investment community anchor on, whether it's market share or revenue goals? And maybe if you could, Chip, just leverage your past history at another company and talk about what you've targeted from a metric standpoint? And then finally, just talk about how sort of senior leadership will be compensated and what metrics you'd be held accountable to?

Okay. The primary issue for us right now is to turnaround the momentum of this business. So the business has clearly been shrinking and decreasing over the last 3 years in its market presence certainly here in the U.S., and you can turn around the business until you stabilize that and start to turn that momentum around. We're making key progress on that and if I was investor in this business, that's what I would be paying a keen attention to, with the more significant report card coming early next year. We're also's making substantive changes on the demand creation side, which I've talked to extensively. But again, you're going to need to judge those based on channel checks and also what happens in the marketplace next year. And obviously, we'll resize the cost structure of this business to fit our estimation of where we are at this point in time. Craig R. Kennison - Robert W. Baird & Co. Incorporated, Research Division: And secondly, if you look over the next, let's say, 3 to 5 years, are there demographic or geographic holes in the portfolio that you think might provide an opportunity for you to grow?

We're a global brand, so one of the great strengths of this business is that we are -- every significant place where people play golf, we are a significant player. We have a strong brand strength, particularly in Asia, so very optimistic for our business going forward there. We have very strong demographics strength within the baby boomer community, which should be a key opportunity for us in the U.S.. And we're also going to be expanding the reaches of the brand going forward with some of the changes we've got. So we think, extensively, that is just a long-winded answer, I guess.

Your next question comes Aziz Pirbhoy with Raymond James. Daniel R. Wewer - Raymond James & Associates, Inc., Research Division: It's Dan right now. So my first question, could you guys just talk a little bit about how Callaway goes about convincing some of its key customers to give it support, especially when it's lost share in recent years?

Dan, that one's easy. That was one of the great -- kind of a little bit surprised and blessed when I got here. I know these customers from previous life and certainly, within the U.S., I know most of them reasonably well and they want Callaway Golf to be successful. They are excited about the changes we're making and they know that it would be good for them to have a strong Callaway Golf. So we don't really have to convince them, we just have to partner with them and listen to them. And candidly, we're getting really good at that. Daniel R. Wewer - Raymond James & Associates, Inc., Research Division: Okay. Switching gears a little bit, I guess. Why was business in the U.S. and Canada incrementally weaker versus 2Q? Is there anything you guys can point to specifically that's changed.

Yes, it is basically sell-through-based. If you look at the beginning of our year, you look at the revenues were roughly flat, but the market share was down. And at some point, you have to address that.

Your next question comes from Jamie Yakaw [ph] with Moab Partners.

I'm trying to understand the rationale behind paying down the credit facility versus redeeming the remaining preferred, convertible preferred. I mean, the strike price is not much higher than where the stock previously closed. And it would seem more economical to redeem those than pay down the credit facility. Just thoughts around that.

Well, this is Brad. And certainly, that's been an option for us, but we're just trying to give ourselves some flexibility right now as we look at the possibilities of other things we might want to use that cash for. We're just evaluating some other opportunities. And so it's not that we won't, it's just we've got some other things to consider at this point in time and it's redeemable at any time at our discretion. So we're not saying we will, we aren't saying we won't, but we're evaluating some other opportunities for use of that cash.

Are you able to disclose any of those opportunities or...

Not at this time. But the intent would be that it would be a better decision to invest in some of these than perhaps even redeeming of the preferred. But certainly, we have that flexibility at our fingertips at any point in time.

[Operator Instructions]

Allie, are there any more questions?

No sir, not at this time.

All right. Well, this is Chip. I just want to thank everybody for calling in today and your precious time, we really appreciate it. Mixed results in the quarter, but we feel like we're well underway on a turnaround plan that's decisive and we are confident in it. We look forward to updating you further at the end of our year results, which should be early next year. Thank you very much for calling.

Thank you for participating in today's conference call. You may now disconnect.