Topgolf Callaway (MODG -1.11%) was formed following the merger of Callaway Golf and Topgolf International in 2021. The company, with a market capitalization of $3.7 billion, is a leader in the overall golf industry, offering popular equipment, clothing, and entertainment options that are likely familiar to many consumers.
Yet, Topgolf Callaway's shares are down 48% from their 2021 high. Propelling this decline, at least more recently, was management's downgraded guidance for the Topgolf segment in the current quarter. This was even after the business beat Wall Street estimates on adjusted earnings per share in Q1.
Despite that pessimism from investors, Topgolf Callaway could be a top growth stock to buy now. Here's why.
Generating positive free cash flow
While Topgolf Callaway has its hand in equipment, apparel, and entertainment, the newly combined entity is burning through cash because of its aggressive pipeline to open more Topgolf locations. In the first three months of 2023, the company's capital expenditures totaled $121 million. Prior to the merger, Callaway Golf's combined capital expenditures in 2018, 2019, and 2020 totaled $131 million.
This makes sense, given that a new Topgolf location costs roughly $30 million on average to build out. And this doesn't even include the cost of the land. This segment represented 35% of the overall business in the first three months of 2023, so it will continue to consume lots of cash going forward.
But cash profits are on the horizon as the company rightsizes its operations and stabilizes its spending. "In the near term, we're increasingly confident in our ability to hit our 2023 expectations, including transitioning to positive free cash flow this year," CEO Chip Brewer said on the first-quarter 2023 earnings call.
The company had $2.2 billion of net debt on its balance sheet as of March 31, so getting its finances in order will be a huge win in the near term. This will help the business depend less on raising external financing, especially beneficial as interest rates are at levels not seen in over a decade.
Growth outlook
With the merger, Topgolf Callaway has breathed some life into its growth prospects. That's because sales of golf equipment, in particular, weren't really a fast-growing business, as you'd imagine. According to Grand View Research, the U.S. golf equipment industry is projected to grow sales at an annualized rate of 4.6% between 2022 and 2030. That's not much faster than long-run gross domestic product growth.
It has also proven to be rather seasonal, dependent largely on the weather. The fourth quarter is usually the worst three months for this segment, as many people stop golfing until things warm up.
But with the entertainment segment of Topgolf, management is expecting big things. There are currently 88 Topgolf locations (five are franchised), with nearly all in the U.S. "We remain on track to open 11 new owned and operated venues in 2023," Brewer mentioned. The business wants to keep up this pace of openings in future years as well.
Looking ahead, it's safe to say that the Topgolf segment will stay the significant growth driver. Off-course golfing, which is exactly what Topgolf specializes in, is growing in popularity. And same-venue sales are up in six straight quarters, despite macro headwinds, like inflationary pressures, that should be hurting discretionary spending.
Taking a closer look at the valuation
A discussion about a business and its investment merits isn't complete without looking at the valuation. As I noted earlier, Topgolf Callaway shares are down 48% from their 2021 peak price. And over the past five years, the stock is down over 4%. This looks terrible compared to the 59% gain of the S&P 500.
But this presents a potential buying opportunity. As of this writing, the stock trades at a price-to-sales ratio of less than 1. That's cheaper than its trailing-10-year average valuation.
A major corporate transaction like the one Topgolf Callaway underwent a couple years ago can be very confusing for investors to analyze. But this business is about to produce positive FCF, has strong growth prospects, and trades at a reasonable valuation. This means that now looks like a good time to take a swing on the stock.
