S&P Global Ratings upgraded the debt ratings of Topgolf International Inc. to ‘B-‘ from ‘CCC+’ on the completion of its merger with Callaway Golf Co. The outlook remains negative.

S&P wrote in a press release:

“The upgrade reflects our belief Topgolf is strategically important to the combined entity and that Callaway will likely support Topgolf under most foreseeable circumstances. Topgolf’s shareholders now own 48.7 percent of the combined entity and have three board seats, thus they can exert significant influence on the combined entity. 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. We believe Callaway’s willingness to fund the merger with $1.7 billion of its stock, as well as its plan to devote 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. Because of this, we raised our issuer credit rating on Topgolf to ‘B-‘, which is one notch higher than our rating on the company on a stand-alone basis. Still, Callaway is not guaranteeing Topgolf’s debt. This raises some doubts about the extent of Callaway’s support if Topgolf encounters significant credit stress, which limits any further notching support.

“We believe Topgolf’s stand-alone capital structure is still unsustainable, although the downside risk to our forecast is mitigated by its harvest case. Even though we forecast Topgolf’s revenue and EBITDA will recover closer to pre-pandemic levels in 2021, we still forecast it will have a very high leverage of about 14x, weak interest coverage of about 1x, and generate negative free cash flow. We view these metrics as unsustainable. Over the next few years, Topgolf will meet its cash investment needs with funding from Callaway. Callaway has significant cash on its balance sheet, partially because of its issuance of $259 million of convertible notes in mid-2020, which it will use to fund much of the commitment. Still, Topgolf must achieve its goal of generating positive free cash flow by 2024, otherwise, we believe it will be difficult to maintain its current pace of investment without pressuring Callaway’s liquidity.

“We believe this risk could be mitigated by Callaway’s ability to enact Topgolf’s harvest case, which includes halting future venue development before breaking ground and cutting discretionary capital expenditures (Capex), allowing Topgolf to harvest the cash flow from its existing venues. Although it would take 9-12 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 allow Topgolf to generate positive free cash flow and EBITDA above its fixed charges.

“The merger will likely improve Topgolf’s growth trajectory, though it will require significant cash investment from Callaway. 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 its goal is for Topgolf to generate positive free cash flow by 2024 when it could become self-funding. However, this is a long time horizon. In addition, we expect significant variability in the company’s operating results depending upon Topgolf’s revenue recovery during and following the pandemic, the pace of the recovery in U.S. economic conditions 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, under which it licenses its technology to driving ranges. Topgolf will also benefit from joint marketing efforts at Callaway that will further increase its exposure, such as by featuring Topgolf’s logos on the apparel worn by PGA Tour professionals at televised tournaments.

“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-price socializing alternatives 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 further growth. Since last summer, the consumer desire for outdoor socially distanced activities has driven a remarkable increase in golf participation. 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 this trend.

“The negative outlook on Topgolf reflects the risk that the company will not expand its EBITDA as quickly as anticipated, which would increase its expected cash funding needs and pressure Callaway’s liquidity.”

Photo courtesy Topgolf