According to multiple studies, as many as 90% of corporate mergers and acquisitions fail. One reason is that companies think they can find "synergies" by combining businesses, and when those synergies don't materialize, the businesses' financials -- and, therefore, share prices -- start underperforming for investors.
Topgolf Callaway Brands (MODG -1.11%) looks like one of the few mergers that could buck this trend. The golf giant and owner of various lifestyle brands has put up promising growth numbers since its merger in 2021 and seems to have a long runway of growth ahead. And yet the stock price has not reflected this growth, with shares down over the last 12 months while the broad market S&P 500 index is up 18%. This indicates a possible buying opportunity in Topgolf Callaway shares at these prices.
Is Topgolf Callaway stock ready to crush the market? Let's take a closer look.
Not just golf equipment but golf entertainment
Callaway merged with Topgolf International in 2021, and the new Topgolf Callaway business operates a ton of different golf and active-lifestyle brands.
The company still owns its flagship golf equipment business and the Odyssey brand of putters. This is a solid business that caters to the avid golfer who is willing to spend hundreds of dollars on golf clubs each year, but it doesn't have crazy growth potential. In fact, up until the last few years, Callaway's golf equipment revenue hadn't grown meaningfully since the late 1990s.
The attractive part of this business, at least from a revenue growth perspective, is the Topgolf business that was acquired in the 2021 merger.
Topgolf is a driving range entertainment concept in which groups of people can play interactive golf games, eat food, and drink alcohol. The segment has fewer than 100 locations around the world, but it did more than $400 million in revenue last quarter, almost as much as the golf equipment segment. Revenue at Topgolf is currently growing 25% year over year and should continue growing at a double-digit rate as more locations open.
Besides Topgolf, this conglomerate now owns lifestyle apparel brands, the most important being Travis Matthew. Revenue in this segment is growing even faster than Topgolf's -- 28% year over year last quarter -- and also presents a long-term growth opportunity that is much stronger than that for golf equipment.
After the merger, Topgolf Callaway has turned itself from a no-growth business that only sold golf equipment to a fast-growing and diversified golf entertainment and lifestyle company. I won't be surprised if consolidated sales grow at a double-digit rate for at least the next five years, if not longer, as more Topgolf venues open.
Focus on a cash flow inflection
The big concern with Topgolf Callaway is cash flow. Even though the business is growing sales at a quick pace, it needs a lot of capital investments to construct new Topgolf locations. Over the last 12 months, Topgolf Callaway has burned $535 million in free cash flow on build-outs.
Management believes the business will hit positive free cash flow by the end of 2023. That's an important target to hit, because the company has a lot of debt on its balance sheet that must be serviced and eventually paid back. At the end of last quarter, the balance sheet carried more than $1.5 billion in long-term debt and $700 million in finance lease obligations, which is quite large for a business that only generates $4 billion in revenue a year.
MODG Free Cash Flow data by YCharts.
If projections are hit, the stock is cheap
The debt is something to keep track of, but if you believe in management's vision of building a golf entertainment brand, Topgolf Callaway looks cheap at its current market cap of $3.7 billion.
In 2023, forward guidance is for the business to reach more than $600 million in adjusted earnings. Today, these adjusted earnings are not converting into free cash flow because of the capital investments in new Topgolf locations. However, management believes adjusted earnings are a good proxy for what Topgolf Callaway could be earning if it stopped reinvesting for growth.
Using these adjusted earnings, Topgolf Callaway shares trade at a dirt-cheap forward price-to-earnings ratio (P/E) of 6. If revenue continues to grow at a double-digit rate, this figure should continue to grow as well, which would make the stock even cheaper. As long as the company starts generating positive free cash flow within the next year, Topgolf Callaway stock looks poised to climb higher over the next five years and beyond.
