Topgolf Callaway: Taking Profit [Rating Downgrade] (NYSE:MODG)

Rating Downgrade

We initiated coverage of Topgolf Callaway Brands Corp (NYSE:MODG) in October of 2022, and since then, the company has rallied more than 20% in less than four months, outperforming the broader index which has risen only 5% in the same time span. Our bullish thesis rested on financial growth, relatively low valuation, and a strong balance sheet that can benefit from secular tailwinds and M&A synergies. We even cited an upcoming Netflix documentary that can help drive interest in the sport forward. Though our long-term expectations are favorable, given the recent rally and increasingly uncertain economic environment, we are downgrading our rating of the company to a “HOLD”.

Recent Updates

Q4 2022 and FY 2022 Earnings

Consistent with our previous thesis, the company has continued to show strong financial growth on a YoY basis. The company posted 20% YoY growth in its net revenue for the fourth quarter along with a greater 156% YoY increase in its adjusted EBITDA. The strong top line growth with margin expansion demonstrates the company’s execution of its M&A and organic growth strategy. FY 2022 revenue segment also demonstrated the company’s diversification, as 35% of its revenue came from golf equipment, 39% came from Topgolf, and 26% came from active lifestyle brands. The company’s financial performance rests on numerous segments and brands and makes the company a diversified play in the golf industry. Despite these strong results, we were less pleased with the company’s FY 2023 guidance as a revenue guidance of $4,415 million to $4,470 million only represents a 10% upside compared to FY 2022. Furthermore, management has guided that the golf equipment segment will likely be flat compared to 2022, which we believe is unideal for a segment that is contributing 35% of its revenue.

Secular Risks

Despite the diversification, Topgolf Callaway Brands operate in a consumer discretionary segment that is focused on entertainment and apparel to consumers. We believe that an economic downturn is likely given the persistent high inflation and consequent prolonged high interest rate environment. In the near-term, if the U.S. economy were to plunge into a U.S. consumer driven recession, Topgolf Callaway could see its revenue decline substantially, as consumers play less golf, purchase less golf apparel items, and other golf-related activities given that it is relatively an expensive sport and method of entertainment. This could severely hinder the company’s current guidance and expectations, and we believe that this risk is stronger today than it was in October of last year. In essence, we believe that at the current valuation rating and the increased likelihood of a recession, our thesis in October no longer holds true.

Elevated Valuation

In the initial coverage article, the company traded around a forward P/E ratio of ~23x. Since the recent rally, the company is now trading at around ~30x forward P/E multiple. The company has gotten 30% more expensive, and even though the recent financial performance has been great, we believe that the risk/reward proposition is now less skewed to the upside. When comparing the company against similar benchmarks in the sports and entertainment industry, the company’s forward P/E valuation remains well elevated over the comps. Though share buyback programs continue to provide support for shareholder value, we believe that given impending near-term risks, the company’s valuation is now less attractive compared to last October.

Conclusion

Our bullish rating in the initial coverage rating has been substantiated by the recent rally as a result of its strong financial performance in the past couple of quarters. However, the valuation is now 30% higher than it was before, with a less than ideal guidance for FY 2023. We also believe that the economic risks remain higher than ever before, which poses substantial risks to a company that needs a strong U.S. consumer base for its financial performance. As a result, we are downgrading our rating to a “HOLD” for MODG stock as we feel more comfortable if the forward P/E valuation was in the 20x range given the current economic conditions.