You might know Topgolf Callaway Brands (MODG -1.48%) as a leader in golf equipment sales. But after its mega-merger (and subsequent name change) in early 2021 with Topgolf, this stock is now much more than just a seller of drivers and putters, having expanded into golf entertainment, driving range software, smartphone games, and golf apparel.

As the company opens up more Topgolf locations and grows Topgolf revenue, its consolidated business becomes less reliant on the cyclical golf equipment industry. This makes the stock potentially undervalued because Wall Street still sees it as a low-growth equipment manufacturer when it is now a fast-growing golf entertainment brand.

But investors have recently turned bearish on Topgolf Callaway after its recent earnings report, sending shares down 12.5% this year while the S&P 500 has shot up 8%. Here's why the stock is underperforming and why the market could be wrong about this golfing, apparel, and entertainment stock.

Q1 earnings: Strong growth at Topgolf and apparel

Topgolf Callaway now has three operating segments: golf equipment, Topgolf, and apparel. In the first quarter, the equipment segment declined slightly, with sales down 5% compared to last year, when it was still seeing benefits from the work-from-home boost to the golf industry. But this was more than made up for with strong growth from Topgolf and apparel.

In the first quarter, Topgolf's revenue grew 25% year over year to $403.5 million, driven by new venue openings and strong 11% same-venue sales growth. Apparel -- led by the TravisMathew and Jack Wolfskin brands -- grew revenue 28% year over year to $320 million.

Combined, the Topgolf Callaway business grew sales 12.2% year over year in the first quarter. If these segment trends continue, Topgolf Callaway will steadily transition more of its revenue from the equipment manufacturing business to the golf entertainment and apparel businesses, which should be a good thing for its earnings power and stock returns.

So what gives? Why is Topgolf Callaway stock down 12% this year?

It all comes down to forward guidance for same-venue sales. Due to a slowdown in corporate events in March, management wanted to be conservative with its second-quarter guidance for Topgolf and now expects same-venue sales to rise by the mid- to high-single-digit percentages in 2023, which is slightly lower than its previous guidance. While this might not seem like much of a change, investors focused on the near term are worried about Topgolf's growth trajectory slowing down.

Free cash flow is key

A slight slowdown in same-venue sales should not be concerning for any Topgolf Callaway investor. The golf entertainment concept has a long runway to grow its locations around the United States (it currently has fewer than 100 active locations), with management expecting to open 11 locations every year for the foreseeable future. As long as same-venue sales growth is 5% to 10% each year, this should lead to steady double-digit revenue growth for the Topgolf segment.

The key for Topgolf Callaway isn't sales growth, it is transitioning from negative to positive free cash flow. Even though each Topgolf location can generate tens of millions in sales each year at maturity, they require lots of up-front capital to build out the real estate.

This has meant a heavy boost to capital expenditures after the Topgolf acquisition, with the company investing $535 million over the past 12 months compared to under $150 million before the merger. This has flipped the company to being heavily free-cash-flow negative, burning $571 million over the past 12 months.

Management believes Topgolf and the consolidated company will get back to positive free cash flow by the end of this year, which should assuage any investor worries over its current sizable cash burn. Perhaps more importantly, it will help the company manage its long-term debt, which sat at $1.5 billion at the end of the quarter.

MODG Capital Expenditures (TTM) Chart

MODG capital expenditures (TTM) data by YCharts. TTM = trailing 12 months.

What about valuation?

After its fall in price, Topgolf Callaway stock now trades at a market capitalization of $3.2 billion. Add back the long-term debt, finance leases, and credit facilities on the balance sheet and subtract its cash balance, and the company currently has an enterprise value of approximately $5.4 billion.

This year, management is guiding for the company to generate $625 million to $640 million in adjusted earnings, which would be less than 10 times its current enterprise value. This looks cheap for a company growing sales by 10% or more per annum.

Of course, adjusted earnings are not perfect, and you should also be tracking whether the company flips to positive cash flow by the end of this year, but there are a lot of indicators that Topgolf Callaway shares are cheap after the company's recent earnings drop.