S&P Global Ratings lowered its debt rating on Callaway Golf Co. to ‘B’  from ‘B+’ due to the completion of its merger with Topgolf International Inc.

The ratings had been placed on CreditWatch with negative implications on October 28, 2020. The outlook is negative.

S&P said in a press release, “The downgrade primarily reflects the combined entity’s high leverage and lower cash flow over the next few years. We believe the incremental leverage at the group entity, along with Callaway’s plan to fund Topgolf’s growth capital expenditures (Capex), will increase the combined company’s financial risk and offset the strategic benefits of the acquisition, including the increase in its scale, the breadth of its products and services, and the pace of its EBITDA expansion over the next few years.

“We view Callaway’s decision to fund the transaction with equity rather than new debt favorably. However, Callaway will consolidate about $500 million of funded debt from Topgolf and more than $1 billion in lease obligations and real estate-related debt. This will significantly increase the leverage of the combined entity to well above our 5x downgrade threshold for Callaway at the previous ‘B+’ rating through at least 2021 because we do not expect Topgolf to generate material EBITDA in 2021. In addition, we estimate the combined company had pro forma leverage of about 15x as of the end of 2020, primarily due to the negative EBITDA at Topgolf, given that its venues were closed during the COVID-19 pandemic, as well as the sustained decline in its group business. Although we believe the transaction will provide the combined entity with an opportunity to accelerate Topgolf’s growth trajectory and eventually lead it to sustained profitability, we believe consolidated leverage will remain high at about 8x in 2021 before declining to the 6x area in 2022 as Topgolf’s venues fully reopen.

“The combined entity will likely have a better growth trajectory, though its expansion will require significant cash investments. In our view, the merger’s benefits for Topgolf are clear: it does not generate free cash flow at its current scale and relies on external capital to add venues to its portfolio. Through the merger, Callaway will finance a significant portion of Topgolf’s venue development for the next several years, enabling it to resume its planned rapid expansion. The company has indicated that its goal is for Topgolf to generate positive free cash flow by 2024, at which time it will become self-funding. However, this is a long time horizon. We expect significant variability in the business’ potential operating results depending upon the pace of the recovery in Topgolf’s revenue both during and after the pandemic, the pace of the recovery in U.S. economic activity and employment, and changes in consumer preferences over time. Callaway also has long-standing relationships with golf courses and driving ranges around the country that Topgolf can leverage to accelerate the growth of its Toptracer range business, which licenses its technology to driving ranges. Topgolf will also benefit from joint marketing efforts at Callaway that will further increase its exposure.

“There are strategic benefits from the transaction for Callaway as well, although they will be less significant than those for Topgolf, in our view. For example, it appears that the largest benefit for Callaway will be the opportunity to actively market its golf and apparel brands and products to Topgolf’s customers. Topgolf estimates that 50 percent of its customers are non-golfers but many show an interest in pursuing golf after visiting a Topgolf venue. Therefore, Callaway may increase its exposure and brand awareness among consumers it would not have easily reached in the past. There is also potential for cross-selling opportunities whereby Callaway can increase its golf equipment and lifestyle apparel sales by selling its goods at Topgolf’s venues. We have not factored in any of these potential synergies into our base-case projections, thus they present some upside to our model.

“The addition of Topgolf increases Callaway’s scale and product breadth, though Topgolf faces significant competition from alternative out-of-home entertainment options. Topgolf provides entertainment options as well as food and beverage services to the general public, corporate customers, and group events. Although we believe Topgolf has a first-mover advantage in creating a unique golf experience, it faces significant competition from alternative out-of-home entertainment options, among other substitutes for consumers’ discretionary leisure and entertainment spending. Its customers may choose lower-priced or alternative venues to socialize that do not involve golfing, eating, or drinking. Continued economic pressure could amplify this risk if consumers limit their spending on discretionary leisure activities.

“The recent surge in the popularity of golf will likely provide a tailwind for the company’s performance. Callaway has recovered rapidly from the early days of the pandemic when coronavirus-related stay-at-home orders temporarily shut down most golf courses, retailers, and manufacturing facilities. Since then, consumer desire for socially distanced outdoor activities has driven a remarkable increase in golf participation and equipment sales. Callaway realized a 15 percent year-over-year increase in its sales and a nearly 50 percent rise in its EBITDA in the second half of 2020. Topgolf enjoyed a similar resurgence in the volume of walk-in traffic at its venues, although its volume of group business is still down substantially and its revenue remains below 2019 levels. It is hard to predict what percentage of the new golfers that entered the sport in 2020 will remain over the long term. However, we expect the surge in participation to be a tailwind for the golf industry over the next several years and anticipate both Callaway and Topgolf will likely benefit from the rise in golf participation.

“The combined entity’s significant Capex needs and high leverage will increase its financial risk, although Topgolf’s harvest case will mitigate the downside risk. Despite the strategic benefits of the acquisition, we believe the combined company’s increased financial risk, due to the leveraging effects of the merger and Callaway’s plan to fund $325 million of Topgolf’s Capex over the next three years, will outweigh the strategic benefits from the combination over the intermediate-term. Callaway has significant cash on its balance sheet, partially because it issued $259 million of convertible notes near the beginning of the pandemic. We expect the company will use its cash balance to fund most of the commitment. However, Callaway will also need to use revolver borrowings or internally generated free cash flow to cover the remainder. Callaway has not generated more than $100 million of free cash flow in any of the past 10 years and we do not expect it to do so in 2021. That said, we project it could meet this level of free cash flow generation by 2022. Nonetheless, Callaway will rely on achieving its goal for Topgolf to generate positive free cash flow by 2024, otherwise, we believe it will be difficult for the company to maintain the current pace of investment at Topgolf, which could reduce Callaway’s free cash flow for a prolonged period.

“Our rating on Callaway relies on its ability to mitigate this risk by enacting Topgolf’s harvest case, which includes halting future venue development before breaking ground and reducing other discretionary Capex, allowing Topgolf to harvest the cash flows from its existing venues. Although it would take 9-to-12 months to work through the near-term spending commitments on its partially built venues, the elimination of growth capital spending and pre-opening expenses beyond this inflection point would likely enable Topgolf to generate positive free cash flow and EBITDA above its fixed charges.

“We believe Topgolf is strategically important to the combined entity and anticipate Callaway will likely support Topgolf under most foreseeable circumstances. Topgolf shareholders now own 48.7 percent of the combined entity and have three board seats, thus they can exert significant influence. Callaway has also made it clear that Topgolf is an important part of the company’s strategy to create an unrivaled golf and entertainment business. The company believes the combination will enhance the growth prospects of both entities. Callaway’s willingness to fund the merger with $1.7 billion of its stock and plan to commit significant cash to fund development at Topgolf further demonstrates this commitment. As such, we believe Callaway would provide extraordinary support to Topgolf under most foreseeable circumstances. Still, Callaway is not providing guarantees to Topgolf’s debt, which raises some doubts about the extent of Callaway’s support in the event Topgolf encounters significant credit stress.”

Photo courtesy Topgolf