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Callaway Golf Co. 10-Q Summary: Period Ended June 30, 2010

Business Context and Reporting Period

This report covers the quarterly period ended June 30, 2010, for Callaway Golf Company, a designer, manufacturer, and seller of golf clubs, golf balls, and related accessories. The company operates two primary segments: Golf Clubs and Golf Balls. The business is highly seasonal, with the majority of sales and profitability typically occurring in the first half of the year. Approximately 50% of the company's business is conducted outside the United States, exposing results to foreign currency fluctuations.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue: Net sales were flat for the second quarter ($303.6M vs. $302.2M in 2009) but increased 6% for the first six months ($606.5M vs. $574.1M in 2009). Growth was driven by foreign currency translation benefits and increased sales of woods, putters, and accessories, offset by lower average selling prices on drivers.
• Profitability: Gross margin improved significantly, increasing 360 basis points to 43% for the six months ended June 30, 2010, compared to 39% in the prior year. This was driven by cost reductions under the "Global Operations Strategy" and favorable currency shifts.
• Operating Expenses: Operating expenses as a percentage of net sales improved by 100 basis points to 34% for the first six months, despite the restoration of certain employee compensation and benefits suspended in 2009.
• Other Income/Expense: The company recorded a net foreign currency loss of $4.7 million in the second quarter and $3.1 million for the six months, compared to a gain of $0.5 million in the second quarter of 2009.
• Segment Performance: The Golf Clubs segment pre-tax income increased 21% in the quarter and 39% for the six months. The Golf Balls segment turned a loss into a profit, with pre-tax income of $5.8 million for the quarter and $7.6 million for the six months.

Guidance, Outlook, and Risks

• Restructuring Initiative: On July 27, 2010, the company announced a restructuring of global manufacturing and distribution operations (reorganizing Carlsbad and Toronto, creating logistics sites in Dallas and Toronto, and establishing a new facility in Monterrey, Mexico). The company expects to incur approximately $24.3 million in charges over the next 18 months.
• Outlook: Management notes unusual uncertainty regarding retailer and consumer spending for the second half of 2010 due to macroeconomic conditions. The company is focused on managing discretionary spending and improving gross margins.
• Liquidity: The company has a $250 million credit facility with no outstanding borrowings as of June 30, 2010. It remains in compliance with all financial covenants.
• Legal Proceedings: Significant ongoing litigation includes patent infringement disputes with Acushnet (Titleist) regarding golf ball patents. A jury recently found Callaway's asserted claims invalid in a retrial, though Callaway has moved for a new trial. The company also faces a lawsuit regarding trade dress infringement of putters.
• Foreign Currency Risk: The company is exposed to fluctuations in foreign exchange rates, which can significantly impact reported results. Hedging activities mitigate but do not eliminate this risk.

Investor Verification Checklist

• Verify the impact of the announced $24.3 million restructuring charges on future earnings and cash flow.
• Monitor the status of the patent litigation with Acushnet, specifically the pending motion for a new trial and PTO reexamination proceedings.
• Assess the sustainability of the improved gross margins (43%) given the challenging market conditions and price reductions on driver products.
• Review the company's ability to maintain compliance with the $250 million credit facility covenants if economic conditions deteriorate further.
• Track the performance of the new production facility in Monterrey, Mexico, and the efficiency gains from the global operations strategy.