Golf equipment company Callaway Golf (MODG 4.49%) posted stellar second-quarter results on Aug. 9, surpassing Wall Street estimates at both the top and bottom line and offering robustly upbeat guidance. Despite this, the stock market bid its share prices down immediately and for several days following, with one day's losses at over 4%.

Digging a little deeper into Callaway's performance, and the performance of the market it's operating in, shows a few potential risks, but also some notable positives.

A golf ball whizzing away from a golfer, with a cirrus covered blue sky in the background.

Image source: Getty Images.

Two quarters of vigor

The first half of 2021 has been a shining financial success for Callaway, with momentum not only continuing but increasing from the first to the second quarter. Q2's overall revenue popped 208% year over year to $914 million, with a 105% rise above Q2 2019's pre-pandemic revenue. Callaway management points out a third of this windfall, $325 million, comes from Topgolf, which it recently acquired.

Even excluding Topgolf's contribution, however, its golf equipment sector revenue soared 91% from 2020 and 37% above 2019, while its apparel and gear sector saw gains of 115% and 21% respectively. Diluted earnings per share rose from Q2 2020's $1.78 loss per share to positive $0.47 earnings per share, with first-half earnings showing a proportionally similar rise. While earnings per share were up year over year, they shrank from Q1's $2.19 EPS, because the merger with Topgolf boosted share count from 94 million shares at Q2 2020's end to 194 million shares at the end of Q2 2021.

Third-quarter and full-year guidance also looks rosy, with revenue expected to be $775 million to $790 million, up from 2019's $426 million and 2020's $476 million. For the whole year, 2019's $1.7 billion and 2020's $1.6 billion are projected to be dwarfed by 2021's $3.03 billion to $3.06 billion. Of course, this reflects not only expected growth but also the contribution of Topgolf.

Still, despite all the positives, a few risks also emerge from Callaway's reporting. One is the sharp increase in its long-term debt, rising from $650 million on Dec. 31, 2020, to $1.06 billion as of June 30. During the Q2 earnings conference call, CFO Brian Lynch noted $632 million in debt came with the Topgolf merger. Countering this, the company ended the second quarter with $877 million in cash and other liquidity, operating cash flow was $272.4 million versus $28.8 million a year ago, and the company gained $171 million in cash from the merger. While debt grew and is worth watching over the next several quarters, the company appears to have enough liquidity and its debt is not a high risk.

Supply chain and raw material problems are another area of mild risk. The company's goods are mostly manufactured in Southeast Asia, where COVID-19 is seeing a resurgence. In its Q2 investor presentation, Callaway said it is shifting production to the factories with the least coronavirus impact, but it expects a revenue drop of $55 million in the year's second half, concentrated in golf equipment. Though not mentioned in the report, metal and resin commodity prices are also rising and could potentially impact future prices.

Finally, there's the matter of the rise in golfing's popularity as the engine driving Callaway's gains. What are the factors driving the demand surge, and how long can it continue? It's time for a detailed look at what's happening on the green.

What is happening in the golfing market?

Strong trends beginning in 2020 and continuing into 2021 have created a very favorable situation for Callaway. Americans, and likely others around the world, have been escaping to the outdoors since COVID-19 prompted governments to begin temporary lockdowns, indoor masking requirements, air travel bans or restrictions, capacity limitations, and other measures. With restaurants, casinos, theme and water parks, cruise ships, churches, and other standard social or entertainment venues either closed or made unpleasant by restrictive safety protocols and the lurking fear of infection, alternate ways to get out of the house and relax saw a powerful upsurge in popularity.

The result of these trends appears across multiple sectors. Recreational vehicles began setting all-time records for shipments and sales during early to mid-2020, with sales still growing fast over a year later in mid-2021. Makers of powersports vehicles like ATVs and motorcycles are registering growth despite price increases due to steel or aluminum price inflation. Gardening and outdoor equipment suppliers and retailers are seeing a boom from the same phenomenon. 

A woman looks out on the field of a Top Golf facility in Texas while standing in a golf box and holding a golf club

Image source: Top Golf.

The same considerations seem to be getting Americans out on the links in record numbers, where enjoyment can be had amid fresh air, freedom from masks, reduced infection risk, and the pleasant surroundings of a well-manicured golf course. According to Golf Digest, citing National Golf Foundation research, the number of golfers in the U.S. rose 2% to 24.8 million, with around a quarter being either new players or returning players who had previously quit. Private golf club rounds increased 20%, public rounds by 12%, and sales of golf equipment rose.

Enthusiasm for golfing is growing even stronger in 2021, according to National Golf Foundation data. June 2021 figures, the most recent available as of early August, show golf rounds up 0.4% for the month year over year. However, considering the first half of the year as a whole, rounds soared 23% compared to 2020's first half, and are up 19% from the average rounds in 2017, 2018, and 2019. With the remaining golf season, the NGF expects rounds to be up approximately 9% year over year for the full annual figure.

NGF CEO Joe Beditz told Golf Digest, "there hasn't been this much optimism and new activity in the golf business since the turn of the century." Similarly, the CEO of golf ball, club, and footwear company Acushnet Holdings remarked, "I tend to look at it as, 'Okay, what's the world going to look like, 2022 versus 2019?' And I think the golf landscape is going to have more energy, more momentum, more golfers." While COVID-19 triggered the initial rise, it appears golfing, along with RV use, gardening, motorcycling, and other outdoor activities, has gained momentum likely to outlast the pandemic, as people continue to engage in new hobbies they enjoy.

What is Callaway teeing up for the future?

Callaway has delivered sizzling results for two quarters in a row, but future sustainability is of prime importance to investors. Fortunately for Callaway and those who hold its stock, it appears the golfing surge still has plenty of life in it going through summer 2021, and several major industry figures expect momentum into 2022. Many new golfers are likely to continue golfing, and any upsurge in COVID-19 over the coming winter could boost the trend next year, too.

Callaway has considerable debt but also plenty of cash and cash equivalents, while supply chain and raw material prices seem to be having a minimal impact thus far. The drop in share prices after the Q2 earnings release may just be investors taking profits, and Callaway Golf looks like one of the leisure stocks that will continue gaining at least into the medium term.