Callaway Golf's (NYSE: ELY ) second-quarter results veered off to the right last week, thanks largely to a hefty increase in cost of goods sold that landed earnings in a bunker.
The company reported earnings of $0.33 a share. That was 22% higher than the second quarter of 2005, but analysts polled by Thomson First Call expected a profit of $0.45 a share. In the second quarter of last year, the company reported gross margins of 45%, while in the second quarter this year, gross margins fell to 41%.
Falling gross margin is not what I was expecting this quarter, especially considering the aggressive cost-cutting program that CEO George Fellows recently announced. He blamed the rise in gross margins on "unanticipated execution issues and cost increases." To me, "execution issues" sounds like code for "somebody screwed up."
Callaway issued a press release five days before the quarterly results, to announce that David Laverty will be taking over the helm of global manufacturing from the departing Bob Penicka. Honestly, I don't know whether Penicka is to blame for the problems with gross margins, but as head of manufacturing, he would have had significant responsibility for keeping the cost of goods down.
In any event, margins kept the ball from flying too far off course in the second quarter. As a percentage of sales, operating expenses improved to 30% from 37% in the second quarter last year. Fellows attributed this improvement to his cost-cutting program, and we can only hope that this success will carry over to other areas of the business. Obviously, gross margin improvement is crucial, but it is also important to see some reduction in inventory levels. Callaway currently has $232 million in net inventory.
Callaway can't seem to consistently put the ball in the fairway, and investors are eager to see improvements. Still, this could be a great turnaround story. Fellows claims to be "comfortable with our three-year corporate targets," and he has put his own money down to prove it. He purchased 10,000 shares at $11.86, and two other Callaway directors have recently made purchases. The shares are definitely cheap, but I'll wait until I see some results before I start buying. Meanwhile, Nike (NYSE: NKE ) or Fortune Brands (NYSE: FO ) , maker of Titleist, aren't quite as risky.
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Fool contributor Brendan Mathews putts with a pool cue, and he welcomes your feedback. He owns shares of Nike. The Motley Fool has a strict disclosure policy.