The S&P 500 index is up 12.6% year to date, as of this writing. This puts the index on pace to beat its long-term average annual return of around 10%, making 2023 a great year so far for stock investors.
But investors in Topgolf Callaway Brands (MODG 0.83%) have not reaped any of these gains. In fact, it has been the opposite. The golfing roll-up that owns equipment, apparel, and entertainment brands has seen its shares sink 30.6% this year and 18% in the last month alone, putting it on pace to be one of the worst-performing stocks of 2023.
The market is clearly bearish on the future of consumer spending for the golf industry. Are these fears warranted, or is now a perfect time to buy the dip on a market leader? Let's take a closer look.
A match made in merger heaven?
During the pandemic, Callaway (as it was called then) decided to merge with Topgolf, a golfing entertainment chain that Callaway had a major investment in. Due to the government shutdowns and stay-at-home orders, Topgolf's business needed a lifeline to get through the pandemic, and Callaway offered one.
The result is Topgolf Callaway, which now has three segments all focused on the golf market: equipment, apparel, and entertainment. Equipment sales are mainly made up of Callaway Golf Clubs. The apparel segment is driven by Travis Matthew, a lifestyle brand that caters to the golf, fitness, and work leisure market. The entertainment division is almost entirely Topgolf, which operates huge driving ranges that host group events and offer games, food, and drinks for guests.
Golf equipment is a durable but low-growth industry, but it should generate cash for the parent company for years to come. Where is that cash being invested? Into growing the number of Topgolf locations around the world, mainly in the United States.
The company plans to open 11 new Topgolf locations this year and around 10 every year this decade. Even though there are currently fewer than 100 Topgolfs around the world, the segment is expected to generate $1.9 billion in revenue this year and $315 million to $325 million in adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA). With inflation, same-venue sales growth, and new locations opening up every year, Topgolf has a fantastic growth opportunity ahead of it and could far surpass its current annual revenue five or 10 years from now.
Cash flow looks bad but should turn the corner soon
So if Topgolf has so much potential, what are investors concerned about? Two things: slowing same-venue sales and heavy cash burn. Let's address both problems and why they should resolve themselves over the next year or two.
Topgolf venues are huge and can accommodate a ton of paying customers at the same time. The outings are not for people looking to penny-pinch, as you will likely spend money on food, drinks, and possibly shop for some golf equipment and apparel on top of your driving range reservation. This has led to fantastic same-venue sales growth for Topgolf over the years.
But last quarter, same-venue sales growth dropped to just 1%, which has investors spooked. However, there is not much to be concerned about because the year-ago quarter included high inflation and booming consumer spending on entertainment. That makes for a tough year-over-year comparison.
As we get into 2024 and 2025, Topgolf same-venue sales growth should start to accelerate again. Management is expecting this rebound to possibly begin in the third quarter with guidance for a 1% to 3% expansion.
Growing Topgolf locations is expensive and requires a ton of capital. This has led to Topgolf Callaway's free cash flow plummeting since the merger, hitting negative $565 million over the last 12 months. While not something that can continue forever, management is expecting its consolidated operations to be free-cash-flow positive in full-year 2023, which should alleviate investor concerns.
Historically, strong retail concepts such as Home Depot and Wal-Mart operated with negative cash flow early on in their growth trajectories due to high capital expenditures, but they were still creating value for shareholders because of the great returns they were getting on this invested capital (ROIC). Topgolf has the same dynamic, setting the business up for strong returns in the years to come.
Data by YCharts.
Is the stock cheap?
Today, Topgolf Callaway has a market cap of about $2.5 billion and an enterprise value of $3.9 billion. This year, management expects the business to generate at least $4.4 billion in revenue and $625 million in adjusted EBITDA. Cash flow will likely be much lower, but over time, it should converge with earnings as the Topgolf business matures. With the growth of Topgolf, I wouldn't be surprised to see the consolidated business generate $1 billion in EBITDA three years from now, if not more. That would give the stock an enterprise-value-to-EBITDA multiple of just 3.9 based on today's share price. Combined with a price-to-sales ratio below 1, that is dirt cheap no matter how you slice it.
Of course, Topgolf Callaway isn't guaranteed to put up these numbers, so investors should track Topgolf's same-venue sales and the company's free cash flow going forward. But if those metrics do rebound as management expects, the stock could deliver terrific returns for shareholders.
