Topgolf Callaway Brands (MODG +7.41%) sells golf equipment and apparel. However, an increasingly large part of this business is its technologically enhanced driving ranges -- its Topgolf brand -- where customers go to hit some balls, eat some food, and have some drinks.
The Topgolf brand accounted for 36% of the company's total revenue in the first three quarters of 2022 and is its fastest growing revenue segment with a 51.6% year-over-year increase. And management says these venues have eye-popping cash-on-cash returns.
Let's see what that could mean for the company -- and its shareholders -- in the year ahead.
NYSE: MODG
Key Data Points
What real estate investors understand
To understand the Topgolf Callaway investment thesis, you need to understand cash-on-cash returns. In real estate, some investors are looking for long-term price appreciation. But others care more about cash flow. And cash-on-cash returns is a metric used to assess cash-flow opportunities.
Here's how it works. Let's say that you invest $100,000 into a piece of real estate that will earn you (net of loan payments) $10,000 annually. That's a 10% cash-on-cash return. For the record, many real estate investors consider 10% cash-on-cash returns pretty good. Getting 20% returns is approaching a home-run opportunity.
According to management, Topgolf venues have 40% to 50% cash-on-cash returns by their third year. Under this equation, any money that the company spends to open new Topgolf locations will be completely earned back during the fifth year, at the latest. When presented with a cash-flow opportunity like this, it makes perfect sense to open as many locations as possible.
Topgolf Callaway aimed to finish 2022 with 81 owned and operated Topgolf locations. The company is expected to report financial results in early February, which is when investors will hear if it met its goal. Over the long term, management believes that there can be 450 Topgolf locations worldwide, a substantial jump from today.
With this kind of growth opportunity and cash-on-cash returns this high, it's easy to envision Topgolf Callaway becoming a cash-cow business over the next decade, which could make it a market-beating stock.
Why it matters and what to watch
The Topgolf growth strategy means two things for shareholders.
First, expect long-term debt to grow substantially in coming years. For company-owned locations, management finances about $22.5 million per new location compared with using $7.5 million of its own money. By 2025, it hopes to have 114 company-owned locations, which could add over $700 million to its current net debt of $1.75 billion.
Therefore, if you're an investor who hates debt, then Topgolf Callaway isn't going to be the stock for you.
Second, great cash-on-cash returns for Topgolf don't necessarily mean that the company's overall cash flow will look good in the near future. Indeed, while management is targeting about $3.7 million in annual cash flow per location, the cost to open new locations will keep this from showing up in financial statements.
For example, through the first three quarters of 2022, the company opened five new owned-and-operated locations and has incurred $18.1 million in venue pre-opening costs -- almost all of the cash flow these locations are expected to generate during their third year. Therefore, investors will need to dig below the headline numbers in coming quarters and years to see if Topgolf Callaway is on track.
A final thought on risk
Topgolf venues have about $17.5 million in annual revenue per location. But the concept is still relatively young, and fixed costs for facilities like these are high. In short, it needs this high revenue per location in order to do well.
But it's possible that its current surge in popularity could fade, new locations might not perform as well as existing locations, and discretionary spending on leisure could go down in 2023 if the U.S. economy goes into a recession.
For these reasons, I believe Topgolf stock is one to be approached with optimism but caution. High fixed costs and a heavy debt load make this company particularly vulnerable if demand falls sharply in the coming year, in my opinion.
However, a long runway for growth and potentially strong cash flow make Topgolf Callaway a stock I'll be watching from here with strong interest.
