You might think that golf is a mature, unexciting business. But don't tell that to Callaway (NYSE:ELY), the maker of Big Bertha drivers and Odyssey putters. Golf is one of the few out-of-home activities that is relatively safe amid the COVID-19 pandemic, and the industry saw an incredible jump in play this summer. According to Callaway, September rounds played are up about 25% compared with last year.

Not only that, but Callaway just made a huge acquisition, betting  big on what could be the tech-enabled future of the sport. In fact, the bet is so big that Callaway's recent acquisition is more like a merger of equals -- and it could either catapult Callaway into amore exciting growth stock status, or potentially sink it as well.

A male golfer  stretches with his driver  behind his head and wears a face mask.

Image source: Getty Images.

Callaway merges with Topgolf

In late October, Callaway announced it would be acquiring Topgolf for roughly $2 billion in stock, while also assuming Topgolf's $555 million in debt. Topgolf is a tech-oriented driving range, restaurant, and entertainment super-center that has experienced rapid growth since its founding in 2005.

Topgolf currently has 58 U.S. driving range venues and five international venues, with some of them franchised. In 2019, the company made $1.1 billion in revenue, growing 30%, and $59 million in adjusted EBITDA. Topgolf also has a tech element to it, having developed its Toptracer technology that tracks a ball mid-flight, provide swing and shot data, and provides the ability to play simulated courses on its ranges. Topgolf has also developed a free-to-pay mobile video game called World Golf Tour with 30 million members that is monetized by in-game ads as well as micro-transactions.

Keep in mind, adjusted EBITDA is not the same thing as profits or cash flow, and the company isn't profitable right now – especially as COVID-19 has damaged traffic to Topgolf. However, once the environment normalizes, Topgolf expects to be free cash flow positive, before growth investments, by 2022, and free cash flow positive overall by 2024.

Wall Street didn't like the transaction

The short-term reaction was a quick 25% drop in Callaway's share price on the Oct. 27 announcement, as investors may have viewed the transaction as a strong business buying a weaker one.

Callaway's core business was up 12% in the third quarter as people flocked to golf courses amid COVID and bought equipment, and earnings per share rocketed 67% as operating expenses declined in the same environment. So, Callaway is using its current strong position to opportunistically purchase Top Golf, whose business is down amid COVID.

Topgolf's model actually more resembles other out-of-home consumer discretionary companies such as restaurants, movies, and bowling rather than golf courses in wide open spaces. The company gets roughly one third of its revenue from game play, one third from food and beverage, and another third from corporate events. As such, business is down, but slowly improving. The company said it had finally fully reopened only as of September.

However, Callaway's price has since recovered nearly all of where it was before the announcement of the transaction on the back of strong earnings as well as positive vaccine news.

But there's a significant bull case

Despite Wall Street's initial reaction, once the world returns to normal, there is a chance this acquisition could look like a genius move down the road. First, the addressable growth runway for Topgolf is very large, at least according to the company. From 58 venues today, management envisions an addressable market of 200 U.S. venues. Internationally, the opportunity is even larger, with just five venues today and a market opportunity of 250. Topgolf could also franchise most of these international venues, giving it a steady stream of lower-risk cash flow.

The technology side of Topgolf also shouldn't be ignored. Its Toptracer technology has been shown to increase engagement and traffic at its venues. Additionally, Topgolf licenses Toptracer to other driving ranges as well. The annual license revenue could be an additional high-quality revenue stream, and the market is large, since there are many more traditional driving ranges than Topgolfs. And of course the video game industry is very strong all over the world, so the jury is out how much World Golf Tour can grow, or if the company can follow up with other games.

Finally, there are ample cross-selling opportunities. Many Topgolf visitors are non-golfers or casual golfers, which Callaway will no doubt try to convert to more full-time golfers to which to sell equipment. At the same time, Callaway's established distribution footprint among club pros and other outlets gives it another channel through which to promote Topgolf products such as Toptracer or games.

But there are risks to consider

Despite the interesting potential of Toptracer and games, most of Topgolf's revenue and profits come from its venues, and these venues take a fair amount of capital with high fixed costs. Over the next three years, the combined companies intend to burn $325 million in cash, investing in new venues, tech capabilities, and venue maintenance. As a somewhat luxurious, fully staffed experience, those high fixed costs mean that people will need to fill up Topgolfs consistently and well into the future. While the company is about 15 years old, it's still unclear if there will be enough demand going forward to fill the footprint it envisions. After all, high fixed costs work both ways.

A path to growth

The number of "on-course" golfers has stagnated over the past decade, while "non-course" golfers who attend ranges and venues like Topgolf have grown at a 6.5% rate since 2014. As such, it's no surprise that Callaway is trying to buy itself into more of a growth industry. Given that the pandemic has provided a short-term bump to Callaway's legacy business and hurt Topgolf, the acquisition could end up being a genius piece of timing on management's part -- that is, if Topgolf can continue to fill up its giant entertainment complexes post-pandemic.

Will it work? Prospective investors may wish to try out a Topgolf near you; if you're impressed, then by all means, invest! If it doesn't "wow" you, there may be other better options in the stock market.