CALY

Business Context and Reporting Period

This Form 10-Q covers Callaway Golf Company for the quarterly and six-month periods ended June 30, 1999. The Company is a leading manufacturer of premium golf equipment, including clubs and golf balls. The reporting period reflects the ongoing implementation of a major restructuring plan initiated in late 1998, which involved consolidating operations, exiting non-core businesses, and resizing the workforce. The Company is also in the development phase of its golf ball business, with a planned launch in early 2000.

Key Financial Metrics

Note: Debt figures represent balances at June 30, 1999. The Line of Credit facility was amended in February 1999 to $120 million, with $118.5 million available at period end.

Material Changes vs. Prior Period

• Revenue: Net sales for the six months ended June 30, 1999, increased 1% to $415.5 million compared to $410.2 million in the prior year. However, sales in the U.S. decreased 8% and in Europe decreased 3%, offset by a 170% increase in sales to the rest of Asia.
• Profitability: Net income for the six-month period rose 16% to $37.6 million, driven by a 16% increase in operating income ($64.3 million vs. $53.2 million). This improvement was largely due to a significant reduction in selling expenses (down 15% to $66.2 million) resulting from the restructuring plan.
• Margins: Gross margin percentage for the six months declined slightly to 46% from 47% in the prior year. Management attributes this to the sale of older products at close-out prices. Excluding these close-out sales, the gross margin would have been 48%.
• Liquidity: Cash and cash equivalents decreased by $18.7 million to $26.9 million. This reduction was primarily due to $36.9 million in investing activities (capital expenditures for golf ball operations) and $64.2 million in financing activities (repayment of credit lines and dividends), partially offset by strong operating cash flow of $82.6 million.

Outlook, Risks, and Management Commentary

• Restructuring Progress: The Company continues to execute a $54.2 million restructuring plan initiated in Q4 1998. Approximately 750 non-temporary workforce reductions occurred in Q1 1999. Future cash outlays for restructuring are estimated at $13.3 million, with $1.6 million expected in the second half of 1999.
• Market Conditions: Management notes a decline in the premium golf equipment market in the U.S., Japan, and Europe, partly due to retail inventory build-ups in 1998. Despite this, the Company believes it gained market share in woods in the U.S.
• Golf Ball Venture: The Company is investing heavily in a new golf ball business, with a new plant under construction and a product launch targeted for early 2000. This venture has negatively impacted cash flows and results of operations in the short term.
• Japan Distribution: The Company is transitioning distribution in Japan from Sumitomo Rubber Industries to its own subsidiary, ERC International Company, effective January 1, 2000. This transition may cause a temporary decrease in shipments in late 1999 as the distributor liquidates inventory.
• Risks: Key risks include product breakage (specifically shaft breakage in "Biggest Big Bertha" drivers), dependence on limited suppliers for titanium and shafts, potential intellectual property disputes, and the impact of "gray market" distribution. The Company also faces Year 2000 (Y2K) compliance risks, though it estimates total remediation costs will not exceed $6.0 million.

Investor Verification Checklist

• Inventory Levels: Verify the adequacy of inventory reserves given the $84.3 million net inventory balance and the risk of obsolescence from close-out sales.
• Japan Transition: Monitor the impact of the distributor change in Japan on Q3 and Q4 1999 sales volumes.
• Golf Ball Costs: Track capital expenditures and operating losses associated with the new golf ball plant and product development.
• Warranty Reserves: Assess the sufficiency of the $38.0 million accrued warranty expense in light of reported shaft breakage issues.
• Debt Covenants: Confirm continued compliance with the fixed charge coverage ratio and other covenants under the amended $120 million credit facility.