Attached files

file filename
EX-31.2 - CERTIFICATION - CALLAWAY GOLF COely-exx312q214.htm
EX-31.1 - CERTIFICATION - CALLAWAY GOLF COely-exx311q214.htm
EXCEL - IDEA: XBRL DOCUMENT - CALLAWAY GOLF COFinancial_Report.xls
EX-32.1 - CERTIFICATION - CALLAWAY GOLF COely-exx321q214.htm

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
ý
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2014
OR
o
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period                      to                     
Commission file number 001-10962  
 
 
 
Callaway Golf Company
(Exact name of registrant as specified in its charter)
 
 
 
Delaware
 
95-3797580
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
2180 Rutherford Road, Carlsbad, CA 92008
(760) 931-1771
(Address, including zip code, and telephone number, including area code, of principal executive offices)
 
  
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Large accelerated filer
 
o
 
Accelerated filer
 
ý
 
 
 
 
 
 
 
Non-accelerated filer
 
o  (Do not check if a smaller reporting company)
 
Smaller reporting company
 
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  ý
As of July 31, 2014, the number of shares outstanding of the Registrant’s common stock outstanding was 77,705,417.
 



Important Notice to Investors Regarding Forward-Looking Statements: This report contains "forward-looking statements" as defined under the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as: "may," "should," "will," "anticipate," "plan," "believe," "project," "estimate," "expect," "strategy," "future," "likely," and similar references to future periods. Forward-looking statements include, among others, statements that relate to future plans, events, liquidity, financial results or performance including, but not limited to, statements relating to future stock repurchases, cash flows and liquidity, compliance with debt covenants, estimated unrecognized stock compensation expense, projected capital expenditures and depreciation and amortization expense, market conditions, future contractual obligations, the realization of deferred tax assets, including loss and credit carryforwards, the reversal of the deferred tax valuation allowance in future periods, future income tax expense, and the continued success of the Company's turnaround plan and the Company's recovery, as well as improved financial results during 2014. These statements are based upon current information and our current beliefs, expectations and assumptions regarding the future of our business, future plans and strategies, projections, anticipated events and trends, the economy and other future conditions. Because forward-looking statements related to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and many of which are outside of our control. As a result of these uncertainties and because the information on which our forward-looking statements is based may ultimately prove to be incorrect, actual results may differ materially from those anticipated. Important factors that could cause actual results to differ include, among others, the following:
certain risks and uncertainties, including changes in capital market or economic conditions, delays, difficulties, changed strategies, or increased costs in implementing the Company’s turnaround plans;
consumer acceptance of and demand for the Company’s products;
future retailer purchasing activity, which can be significantly affected by adverse industry conditions and overall retail inventory levels;
the level of promotional activity in the marketplace;
future consumer discretionary purchasing activity, which can be significantly adversely affected by unfavorable economic or market conditions;
future changes in foreign currency exchange rates and the degree of effectiveness of the Company’s hedging programs;
adverse changes in the credit markets or continued compliance with the terms of the Company’s credit facilities;
delays, difficulties or increased costs in the supply of components needed to manufacture the Company’s products or in manufacturing the Company’s products;
adverse weather conditions and seasonality;
any rule changes or other actions taken by the USGA or other golf association that could have an adverse impact upon demand or supply of the Company’s products;
the ability of the Company to protect its intellectual property rights;
a decrease in participation levels in golf;
the effect of terrorist activity, armed conflict, natural disasters or pandemic diseases on the economy generally, on the level of demand for the Company’s products or on the Company’s ability to manage its supply and delivery logistics in such an environment; and
the general risks and uncertainties applicable to the Company and its business.
For details concerning these and other risks and uncertainties, see Part I, Item IA, “Risk Factors” contained in the Company’s most recent Annual Report on Form 10-K, as well as the Company’s Quarterly Reports on Form 10-Q and Current Report on Form 8-K subsequently filed with the Commission from time to time. Investors should not to place undue reliance on these forward-looking statements, which are are on current information and speak only as of the date hereof. The Company undertakes no obligation to update any forward-looking statements to reflect new information or events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Investors should also be aware that while the Company from time to time does communicate with securities analysts, it is against the Company’s policy to disclose to them any material non-public information or other confidential commercial information. Furthermore, the Company has a policy against distributing or confirming financial forecasts or projections issued by analysts and any reports issued by such analysts are not the responsibility of the Company. Investors should not assume that the Company agrees with any report issued by any analyst or with any statements, projections, forecasts or opinions contained in any such report.



2


Callaway Golf Company Trademarks: The following marks and phrases, among others, are trademarks of Callaway Golf Company: Anypoint-Apex- Apex Pro-Backstryke-Big Bertha-Big Bertha Alpha-Black Series Tour Designs-Callaway-Callaway Golf-C Grind-Chev-Chev 18-Chevron Device-CXR-D.A.R.T.-Demonstrably Superior and Pleasingly Different-Divine-Eagle-ERC-FTiZ-FT Optiforce-FT Performance-FT Tour-Fusion-Gems-Great Big Bertha-Heavenwood-HX-HX Bite-HX Diablo-Hex Aerodynamics-Hex Black Tour-Hex Control-Hex Chrome- Hex Chrome +-Hex Hot-Hex Diablo-Hex Pro-Hex Solaire-Hex Warbird-IMIX-Legacy-Legacy Aero-Legend-Mack Daddy 2-Marksman-Metal-X-Number One Putter in Golf-Odyssey-OptiFit-ORG.14-ProType-ProType Black-Razr Fit-Razr Fit Xtreme-Razr Hawk-Razr X-Razr XF-Razr X HL-Razr X Muscleback-Razr X Tour-Rossie-S2H2-Sabertooth-Solaire-SR1-SR2-SR3-Speed Regime-Steelhead-Strata-Stronomic-Sure-Out-Tank-Teron-Tech Series-Ti-Hot-Tour Authentic-Tour i-Tour i(S)-Tour iX-Tour i(Z)-Trade In! Trade Up!-Tru Bore-uDesign-uPro-Versa-VFT-Warbird-White Hot-White Hot Tour-White Hot Pro-White Ice-World's Friendliest-X-Act-X Forged-X Hot-X Hot- X2 Hot-X2 Hot Pro-XJ Series-X-SPANN-Xtra Traction Technology-X Utility-XTT-Xtra Width Technology-XWT-2-Ball-3 Deep





3


CALLAWAY GOLF COMPANY
INDEX

 
 
 
Item 1.
 
 
 
 
 
 
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Item 4.
 
 
 
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.


4


PART I. FINANCIAL INFORMATION
Item 1.    Financial Statements (Unaudited)
CALLAWAY GOLF COMPANY
CONSOLIDATED CONDENSED BALANCE SHEETS
(Unaudited)
(In thousands, except share and per share data)
 
June 30,
2014
 
December 31,
2013
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
28,985

 
$
36,793

Accounts receivable, net
196,660

 
92,203

Inventories
208,796

 
263,492

Deferred taxes, net
6,492

 
6,419

Other current assets
20,236

 
22,696

Total current assets
461,169

 
421,603

Property, plant and equipment, net
65,839

 
71,341

Intangible assets, net
88,866

 
88,901

Goodwill
29,367

 
29,212

Deferred taxes, net
2,336

 
2,299

Other assets
54,747

 
50,507

Total assets
$
702,324

 
$
663,863

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable and accrued expenses
$
101,004

 
$
157,120

Accrued employee compensation and benefits
28,956

 
31,585

Asset-based credit facility
60,206

 
25,660

Accrued warranty expense
7,396

 
6,406

Income tax liability
2,713

 
5,425

Total current liabilities
200,275

 
226,196

Long-term liabilities:
 
 
 
Income tax payable
5,384

 
4,387

Deferred taxes, net
35,265

 
35,271

Convertible notes, net (Note 3)
108,200

 
107,835

Long-term incentive compensation and other
2,237

 
5,555

Commitments and contingencies (Note 12)

 

Shareholders’ equity:
 
 
 
Preferred stock, $0.01 par value, 3,000,000 shares authorized, none issued and outstanding at June 30, 2014 and December 31, 2013

 

Common stock, $0.01 par value, 240,000,000 shares authorized, 78,373,598 and 78,314,902 shares issued at June 30, 2014 and December 31, 2013, respectively
784

 
783

Additional paid-in capital
207,147

 
205,712

Retained earnings
134,159

 
77,038

Accumulated other comprehensive income
16,864

 
12,177

Less: Common stock held in treasury, at cost, 697,012 and 967,089 shares at June 30, 2014 and December 31, 2013, respectively
(7,991
)
 
(11,091
)
Total shareholders’ equity
350,963

 
284,619

Total liabilities and shareholders’ equity
$
702,324

 
$
663,863



The accompanying notes are an integral part of these financial statements.


5


CALLAWAY GOLF COMPANY
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share data)
 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2014
 
2013
 
2014
 
2013
Net sales
$
231,893

 
$
249,646

 
$
583,767

 
$
537,402

Cost of sales
141,087

 
153,994

 
328,064

 
311,314

Gross profit
90,806

 
95,652

 
255,703

 
226,088

Operating expenses:
 
 
 
 
 
 
 
Selling expense
60,604

 
61,672

 
137,915

 
129,980

General and administrative expense
12,545

 
15,169

 
30,541

 
29,756

Research and development expense
6,846

 
7,333

 
14,759

 
14,746

Total operating expenses
79,995

 
84,174

 
183,215

 
174,482

Income from operations
10,811

 
11,478

 
72,488

 
51,606

Interest income
282

 
347

 
325

 
400

Interest expense
(2,894
)
 
(2,817
)
 
(5,585
)
 
(5,027
)
Other (expense) income, net
(2,957
)
 
2,498

 
(5,200
)
 
8,656

Income before income taxes
5,242

 
11,506

 
62,028

 
55,635

Income tax provision
1,873

 
1,435

 
3,347

 
3,904

Net income
3,369

 
10,071

 
58,681

 
51,731

Dividends on convertible preferred stock

 
783

 

 
1,566

Net income allocable to common shareholders
$
3,369

 
$
9,288

 
$
58,681

 
$
50,165

Earnings per common share:
 
 
 
 
 
 
 
Basic
$
0.04

 
$
0.13

 
$
0.76

 
$
0.71

Diluted
$
0.04

 
$
0.12

 
$
0.66

 
$
0.59

Weighted-average common shares outstanding:
 
 
 
 
 
 
 
Basic
77,633

 
71,111

 
77,502

 
71,086

Diluted
78,560

 
86,349

 
93,367

 
92,235


















The accompanying notes are an integral part of these financial statements.


6


CALLAWAY GOLF COMPANY
CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
(In thousands)
 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2014
 
2013
 
2014
 
2013
Net income
$
3,369

 
$
10,071

 
$
58,681

 
$
51,731

Other comprehensive income:
 
 
 
 
 
 
 
Foreign currency translation adjustments
4,514

 
(5,702
)
 
4,687

 
(13,834
)
Comprehensive income
$
7,883

 
$
4,369

 
$
63,368

 
$
37,897









































The accompanying notes are an integral part of these financial statements.


7


CALLAWAY GOLF COMPANY
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)
 
Six Months Ended 
 June 30,
 
2014
 
2013
Cash flows from operating activities:
 
 
 
Net income
$
58,681

 
$
51,731

Adjustments to reconcile net income to net cash used in operating activities:
 
 
 
Depreciation and amortization
11,157

 
13,428

Deferred taxes
172

 
200

Non-cash share-based compensation
2,539

 
1,670

Loss (gain) on disposal of long-lived assets
(644
)
 
2,644

Discount amortization on convertible notes
365

 
344

Change in assets and liabilities:
 
 
 
Accounts receivable, net
(100,409
)
 
(144,686
)
Inventories
59,198

 
14,381

Other assets
5,708

 
(2,875
)
Accounts payable and accrued expenses
(60,319
)
 
(7,289
)
Accrued employee compensation and benefits
(2,810
)
 
4,816

Accrued warranty expense
990

 
702

Income taxes receivable/payable
(2,692
)
 
(31
)
Other liabilities
(3,271
)
 
(2,075
)
Net cash used in operating activities
(31,335
)
 
(67,040
)
Cash flows from investing activities:
 
 
 
Capital expenditures
(6,238
)
 
(6,004
)
Proceeds from sales of property and equipment
177

 
3,935

Investment in golf-related ventures
(4,522
)
 
(1,480
)
Net cash used in investing activities
(10,583
)
 
(3,549
)
Cash flows from financing activities:
 
 
 
Proceeds from credit facilities, net
34,536

 
38,500

Exercise of stock options
2,005

 

Dividends paid
(1,551
)
 
(2,989
)
Credit facility amendment costs
(584
)
 

Equity issuance costs
(10
)
 

Net cash provided by financing activities
34,396

 
35,511

Effect of exchange rate changes on cash and cash equivalents
(286
)
 
13,034

Net decrease in cash and cash equivalents
(7,808
)
 
(22,044
)
Cash and cash equivalents at beginning of period
36,793

 
52,003

Cash and cash equivalents at end of period
$
28,985

 
$
29,959

Supplemental disclosures:
 
 
 
Cash paid for income taxes, net
$
5,951

 
$
3,578

Cash paid for interest and fees
$
5,124

 
$
3,632

Noncash investing and financing activities:
 
 
 
Dividends payable
$

 
$
131

Issuance of treasury stock from the settlement of compensatory stock awards
$
87

 
$
1,649

Acquisition of treasury stock for minimum statutory withholding taxes
$
(7
)
 
$
(364
)
Accrued capital expenditures at period end
$
562

 
$
550



The accompanying notes are an integral part of these financial statements.


8


CALLAWAY GOLF COMPANY
CONSOLIDATED CONDENSED STATEMENT OF SHAREHOLDERS’ EQUITY
(Unaudited)
(In thousands)
 
 
Common Stock
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Treasury Stock
 
 

 
Shares
 
Amount
 
 
 
 
Shares
 
Amount
 
Total
Balance at December 31, 2013
78,315

 
$
783

 
$
205,712

 
$
77,038

 
 
$
12,177

 
 
(967
)
 
$
(11,091
)
 
$
284,619

Acquisition of treasury stock

 

 

 

 
 

 
 
(1
)
 
(7
)
 
(7
)
Compensatory awards released from restriction
58

 
1

 
(87
)
 

 
 

 
 
8

 
86

 

Exercise of stock options

 

 
(1,016
)
 

 
 

 
 
263

 
3,021

 
2,005

Equity issuance costs

 

 
(10
)
 

 
 

 
 

 

 
(10
)
Share-based compensation

 

 
2,539

 

 
 

 
 

 

 
2,539

Stock dividends
1

 

 
9

 
(9
)
 
 

 
 

 

 

Cash dividends

 

 

 
(1,551
)
 
 

 
 

 

 
(1,551
)
Equity adjustment from foreign currency translation

 

 

 

 
 
4,687

 
 

 

 
4,687

Net income

 

 

 
58,681

 
 

 
 

 

 
58,681

Balance at June 30, 2014
78,374

 
$
784

 
$
207,147

 
$
134,159

 
 
$
16,864

 
 
(697
)
 
$
(7,991
)
 
$
350,963
















The accompanying notes are an integral part of these financial statements.


9


CALLAWAY GOLF COMPANY
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Basis of Presentation
The accompanying unaudited consolidated condensed financial statements have been prepared by Callaway Golf Company (the “Company” or “Callaway Golf”) pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) have been condensed or omitted. These consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC. These consolidated condensed financial statements, in the opinion of management, include all the normal and recurring adjustments necessary for the fair presentation of the financial position, results of operations and cash flows for the periods and dates presented. Interim operating results are not necessarily indicative of operating results for the full year.
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions.
Recent Accounting Standards
In June 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-12, "Compensation - Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period." This ASU requires that a performance target that affects vesting and that could be achieved after the requisite service period, be treated as a performance condition. The performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. The requisite service period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. This ASU is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Earlier adoption is permitted. The Company is currently evaluating the impact this ASU will have on its consolidated condensed financial statements.
In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers: (Topic 606)." This ASU affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (e.g., insurance contracts or lease contracts). This ASU will supersede the revenue recognition requirements in Topic 605, "Revenue Recognition," and most industry-specific guidance. In addition, the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer (e.g., assets within the scope of Topic 360, "Property, Plant, and Equipment," and intangible assets within the scope of Topic 350, "Intangibles-Goodwill and Other") are amended to be consistent with the guidance on recognition and measurement (including the constraint on revenue) in this ASU. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The amendments in this ASU are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early adoption is not permitted. The Company is currently evaluating the impact this ASU will have on its consolidated condensed financial statements.
In July 2013, the FASB issued ASU No. 2013-11, "Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (a consensus of the FASB Emerging Issues Task Force)." This ASU states that an unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except in certain situations. This ASU is effective for fiscal years, and interim periods within


10


those years, beginning after December 15, 2013. The amendments should be applied prospectively to all unrecognized tax benefits that exist at the effective date. The adoption of this amendment did not have a material impact on the Company’s consolidated condensed financial statements.
In March 2013, the FASB issued ASU No. 2013-05, “Foreign Currency Matters (Topic 830): Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity.” This ASU provides guidance on releasing cumulative translation adjustments to net income when an entity ceases to have a controlling financial interest in a subsidiary or business within a foreign entity. The cumulative translation adjustments should be released only if the sale or transfer results in the complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets resides. This ASU is effective on a prospective basis for fiscal years and interim reporting periods within those years, beginning after December 15, 2013. The adoption of this amendment did not have a material impact on the Company’s consolidated condensed financial statements.
Note 2. Cost Reduction Initiatives
In December 2013, the Company completed its cost reduction initiatives (the “Cost Reduction Initiatives”), which streamlined and simplified the Company’s organizational structure and changed the manner in which the Company approaches and operates its business. These initiatives included (i) a reduction in workforce that impacted all regions and levels of the organization in addition to other transition costs; (ii) greater focus on the Company’s core product lines, which included the transition of the Company's apparel and footwear product lines to a licensing arrangement with third parties; (iii) the transition of the Company’s GPS device business to a third-party based model; and (iv) the reorganization of the Company’s golf ball manufacturing supply chain, including the sale and lease-back of the Company’s ball manufacturing facility in Chicopee, Massachusetts (Note 6).
In the aggregate through December 31, 2013, the Company recognized total charges of $70,600,000 in connection with these initiatives, of which approximately two-thirds resulted in non-cash charges.
During the three and six months ended June 30, 2013, the Company recognized total cash and non-cash charges of $4,998,000 and $8,507,000, respectively, in connection with these initiatives. Amounts recognized in cost of sales during the three and six months ended June 30, 2013 totaled $4,087,000 and $6,369,000, respectively, and the amounts recognized in operating expenses totaled $911,000 and $2,138,000, respectively. Non-cash charges recognized in the first six months of 2013 included lower of cost or market adjustments to inventory as well as inventory write-offs related to the Company's golf apparel, golf footwear and GPS device businesses. The Company did not recognize any charges in connection with the Cost Reduction Initiatives during the three and six months ended June 30, 2014. Amounts payable as of June 30, 2014 included ongoing severance payments and transition costs in connection with the restructuring of the Company's distribution facility in Canada. See Note 16 for charges recognized by the Company’s operating segments.


11


The table below depicts the activity and liability balances recorded as part of the Cost Reduction Initiatives (in thousands) as of June 30, 2014 and 2013. Amounts payable as of June 30, 2014 and December 31, 2013 are included in accrued employee compensation and benefits, and accounts payable and accrued expenses in the accompanying consolidated condensed balance sheets.
 
Cost Reduction Initiatives
 
Workforce
Reductions
 
Transition
Costs
 
Asset
Write-offs
 
Total
Six months ended June 30, 2013
 
 
 
 
 
 
 
Restructuring payable balance, December 31, 2012
$
4,531

 
$
591

 
$

 
$
5,122

Charges to cost and expense
1,091

 
2,418

 

 
3,509

Non-cash items

 
(1,699
)
 

 
(1,699
)
Cash payments
(3,547
)
 
(717
)
 

 
(4,264
)
Restructuring payable balance, March 31, 2013
$
2,075

 
$
593

 
$

 
$
2,668

Charges to cost and expense
677

 
997

 
3,324

 
4,998

Non-cash items

 
(412
)
 
(3,324
)
 
(3,736
)
Cash payments
(1,652
)
 
(1,071
)
 

 
(2,723
)
Restructuring payable balance, June 30, 2013
$
1,100


$
107


$

 
$
1,207

 
 
 
 
 
 
 
 
Six months ended June 30, 2014
 
 
 
 
 
 
 
Restructuring payable balance, December 31, 2013
$
806

 
$
2,501

 
$

 
$
3,307

Cash payments
(476
)
 
(1,355
)
 

 
(1,831
)
Restructuring payable balance, March 31, 2014
$
330

 
$
1,146

 
$

 
$
1,476

Cash payments
(209
)

(203
)


 
(412
)
Restructuring payable balance, June 30, 2014
$
121

 
$
943

 
$

 
$
1,064

Note 3. Financing Arrangements
In addition to cash on hand, as well as cash generated from operations, the Company relies on its asset-based revolving credit facility to manage seasonal fluctuations in liquidity and to provide additional liquidity when the Company’s operating cash flows are not sufficient to fund the Company’s requirements. The Company’s ability to generate sufficient positive cash flows from operations is subject to many risks and uncertainties, including future economic trends and conditions, the success of the Company’s multi-year turnaround, demand for the Company’s products, foreign currency exchange rates, and the other risks and uncertainties applicable to the Company and its business. If the Company is unable to grow sales and generate sufficient cash flows to fund its business, and is unable to reduce its manufacturing costs and operating expenses to offset such shortfall, the Company will need to increase its reliance on its credit facility for needed liquidity. If the Company’s current credit facility is not available or sufficient and the Company could not secure alternative financing arrangements, the Company’s future operations would be significantly, adversely affected. The Company believes that its current credit facility, along with its cash on hand and cash flows expected to be generated from operations, is sufficient to meet the Company’s liquidity requirements for at least the next 12 months.
Asset-Based Revolving Credit Facility
The Company has a Loan and Security Agreement with Bank of America N.A. (as last amended in June 2014, the “ABL Facility”), which provides a senior secured asset-based revolving credit facility of up to $230,000,000, comprised of a $160,000,000 U.S. facility, a $25,000,000 Canadian facility, and a $45,000,000 United Kingdom facility, in each case subject to borrowing base availability under the applicable facility. The amounts outstanding under the ABL Facility are secured by certain assets, including cash (to the extent pledged by the Company), inventory and accounts receivable, of the Company’s U.S., Canadian and U.K. legal entities.
As of June 30, 2014, the Company had $60,206,000 in borrowings outstanding under the ABL Facility, $1,326,000 in outstanding letters of credit and $28,985,000 in cash and cash equivalents. The maximum amount of additional indebtedness (as defined by the ABL Facility) that could have been outstanding on June 30, 2014, after outstanding borrowings, letters of credit and the $23,000,000 fixed charge coverage ratio covenant (defined below) was approximately $41,944,000, resulting in total available liquidity of $70,929,000. The maximum availability under the ABL Facility fluctuates with the general seasonality of


12


the business and increases and decreases with changes in the Company’s inventory and accounts receivable balances. The maximum availability is at its highest during the first half of the year when the Company’s inventory and accounts receivable balances are higher and then decreases during the second half of the year when the Company’s accounts receivable balances are lower due to an increase in cash collections. Average outstanding borrowings during the six months ended June 30, 2014 were $110,865,000 and average available liquidity, defined as cash on hand combined with amounts available under the ABL Facility after outstanding borrowings, letters of credit and the $23,000,000 fixed charge coverage ratio covenant (defined below) was approximately $71,961,000. Amounts borrowed under the ABL Facility may be repaid and reborrowed as needed. The entire outstanding principal amount (if any) is due and payable at the earlier of (a) the date that is six months prior to the maturity of the Company’s 3.75% Convertible Senior Notes maturing on August 15, 2019 or (b) June 23, 2019, if a qualifying refinancing of the Company’s 3.75% Convertible Senior Notes due 2019 has occurred at least six months prior to their maturity.
The ABL Facility includes certain restrictions including, among other things, restrictions on incurrence of additional debt, liens, dividends, stock repurchases and other restricted payments, asset sales, investments, mergers, acquisitions and affiliate transactions. As of June 30, 2014, the Company was in compliance with all covenants of the ABL Facility. Additionally, the Company is subject to compliance with a fixed charge coverage ratio covenant during, and continuing 30 days after, any period in which the Company’s borrowing base availability, as amended, falls below $23,000,000. The Company would not have met the fixed charge coverage ratio as of June 30, 2014, however, the Company’s borrowing base availability was above $23,000,000 during the six months ended June 30, 2014, and as such, the Company was not subject to compliance with the fixed charge coverage ratio convenant.
The interest rate, as amended, applicable to outstanding loans under the ABL Facility fluctuates depending on the Company’s “availability ratio," which is expressed as a percentage of (a) the average daily availability under the ABL Facility to (b) the sum of the Canadian, the U.K. and the U.S. borrowing bases, as adjusted. The applicable margin for any month will be reduced by 0.25% if the Company’s availability ratio is greater than or equal to 67% and the Company’s “leverage ratio” (as defined below) is less than 4.0 to 1.0 as of the last day of the month for which financial statements have been delivered, so long as no default or event of default exists. The Company’s “leverage ratio” is the ratio of the amount of debt for borrowed money to the twelve-month trailing EBITDA (as defined in the ABL Facility), each determined on a consolidated basis. At June 30, 2014, the Company’s trailing twelve months average interest rate applicable to its outstanding loans under the ABL Facility, including fees, was 4.53%.
Origination fees of $4,889,000 incurred in connection with the ABL Facility are amortized into interest expense over the term of the ABL Facility agreement. Unamortized origination fees at June 30, 2014 and December 31, 2013 totaled $2,459,000 and $2,295,000, respectively, of which $492,000 and $918,000 were included in other current assets, respectively, and $1,967,000 and $1,377,000 were included in other assets, respectively, in the accompanying consolidated condensed balance sheets.
Convertible Senior Notes
In August 2012, the Company issued $112,500,000 of 3.75% Convertible Senior Notes (the “convertible notes”). The convertible notes pay interest of 3.75% per year on the principal amount, payable semiannually in arrears on February 15 and August 15 of each year. The convertible notes mature on August 15, 2019.
The Company incurred transactional fees of $3,537,000, which are being amortized into interest expense over the term of the convertible notes. Unamortized transaction fees as of June 30, 2014 and December 31, 2013 were $2,611,000 and $2,863,000, respectively, of which $505,000 was included in other current assets as of both June 30, 2014 and December 31, 2013, and $2,106,000 and $2,358,000 were included in other assets as of June 30, 2014 and December 31, 2013, respectively, in the accompanying consolidated condensed balance sheets.
The net carrying amount of the convertible notes as of June 30, 2014 and December 31, 2013 was $108,200,000 and $107,835,000, respectively. The unamortized discount of $4,300,000 as of June 30, 2014 will be amortized to interest expense over the remaining term of approximately 5.2 years. Total interest and amortization expense recognized during the three and six months ended June 30, 2014 was $1,238,000 and $2,474,000, respectively, and $1,230,000 and $2,439,000 for the three and six months ended June 30, 2013, respectively.
The notes are convertible, at the option of the note holder, at any time on or prior to the close of business on the business day immediately preceding August 15, 2019, into shares of common stock at an initial conversion rate of 133.3333 shares per $1,000 principal amount of convertible notes, which is equal to 15,000,000 shares of common stock at a conversion price of approximately $7.50 per share, subject to customary anti-dilution adjustments. Upon the occurrence of certain change of control events of the Company, the Company will pay a premium on the convertible notes converted in connection with such change of control events by increasing the conversion rate on such convertible notes.


13


Under certain circumstances, the Company has the right to terminate the right of note holders to convert their convertible notes. If the Company exercises such termination right prior to August 15, 2015, each note holder who converts its convertible notes after receiving notice of such exercise will receive a make-whole payment in cash or common stock, as the Company may elect, with respect to the convertible notes converted.
Upon the occurrence of a change of control of the Company or a termination of trading of the common stock of the Company, note holders will have the option to require the Company to repurchase for cash all or any portion of such note holder’s convertible notes at a price equal to 100% of the principal amount of the repurchased convertible notes, plus accrued and unpaid interest thereon to the repurchase date.
The convertible notes are not redeemable by the Company prior to August 15, 2015. On or after August 15, 2015, the convertible notes are redeemable in whole or in part at the option of the Company at a redemption price equal to 100% of the principal amount of the convertible notes to be redeemed, plus accrued and unpaid interest thereon to the redemption date.
The convertible notes contain certain covenants including payment of principal, certain repurchase obligations and interest, obligations of the Company to convert the convertible notes, and other customary terms as defined in the Indenture. The Company remained in compliance with these covenants as of June 30, 2014.
Note 4. Preferred Stock
In August 2013, the Company exchanged 233,843 shares of its 7.50% Series B Cumulative Perpetual Convertible Preferred Stock, $0.01 par value, (the “preferred stock”) for 3,316,922 shares of the Company's common stock at the stated conversion rate of 14.1844 plus an additional 75,342 common shares as an inducement. The Company also paid the exchanging holders cash dividends through December 15, 2013 on their shares of preferred stock surrendered in the exchange. During the fourth quarter of 2013, the Company issued a notice of redemption and holders of 183,496 shares of preferred stock converted their holdings for 2,602,770 shares of common stock at the conversion rate of 14.1844. The Company redeemed the remaining 300 shares for $30,000 in cash. At December 31, 2013 and June 30, 2014, there were no shares outstanding of the Company's Series B Cumulative Perpetual Convertible Preferred Stock.
Note 5. Earnings per Common Share
Earnings per common share, basic, is computed by dividing net income less preferred stock dividends (i.e., net income allocable to common shareholders) by the weighted-average number of common shares outstanding for the period.
Earnings per common share, diluted, is computed by dividing net income adjusted for preferred stock dividends and the interest on the convertible notes by the weighted-average number of common shares - diluted. Dilutive securities are included in the calculation of diluted earnings per common share using the treasury stock method and the if-converted method in accordance with Accounting Standards Codification (“ASC”) Topic 260, “Earnings per Share.” Dilutive securities include the common stock equivalents of convertible preferred stock and convertible notes, options granted pursuant to the Company’s stock option plans and outstanding restricted stock units granted to employees and non-employee directors (see Note 13). There were no shares outstanding of the Company's Series B Cumulative Perpetual Convertible Preferred Stock as of June 30, 2014 (see Note 4).
Weighted-average common shares outstanding-diluted is the same as weighted-average common shares outstanding-basic in periods when a net loss is reported or in periods when diluted earnings per share is higher than basic earnings per share.  


14


The following table summarizes the computation of basic and diluted earnings per share (in thousands, except per share data):
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2014
 
2013
 
2014
 
2013
Earnings per common share—basic
 
 
 
 
 
 
 
Net income
$
3,369

 
$
10,071

 
$
58,681

 
$
51,731

Less: Preferred stock dividends

 
783

 

 
1,566

Net income allocable to common shareholders
$
3,369

 
$
9,288

 
$
58,681

 
$
50,165

Weighted-average common shares outstanding—basic
77,633

 
71,111

 
77,502

 
71,086

Basic earnings per common share
$
0.04

 
$
0.13

 
$
0.76

 
$
0.71

Earnings per common share—diluted
 
 
 
 
 
 
 
Net income
3,369

 
$
10,071

 
$
58,681

 
$
51,731

Less: Preferred stock dividends

 
783

 

 

Add: Interest on convertible debt, net of tax
1,239

 
1,230

 
2,475

 
2,439

Net income including assumed conversions
$
4,608

 
$
10,518

 
$
61,156

 
$
54,170

Weighted-average common shares outstanding—basic
77,633

 
71,111

 
77,502

 
71,086

Convertible notes weighted-average shares outstanding

 
15,000

 
15,000

 
15,000

Preferred stock weighted-average shares outstanding

 

 

 
5,924

Options and restricted stock
927

 
238

 
865

 
225

Weighted-average common shares outstanding—diluted
78,560

 
86,349

 
93,367

 
92,235

Dilutive earnings per common share
$
0.04

 
$
0.12

 
$
0.66

 
$
0.59

For the three months ended June 30, 2014 and 2013, securities outstanding totaling approximately 15,981,000 (including common shares underlying convertible senior notes of 15,000,000) and 6,162,000 shares, (including common shares underlying 5,924,000 preferred shares) respectively, have been excluded from the calculation of earnings per common share - diluted as their effect would be antidilutive. For the six months ended June 30, 2014 and 2013, securities totaling approximately 1,053,000 and 6,071,000, respectively, comprised of options and restricted stock, have been excluded from the calculation of earnings per common share - diluted, as their effect would be antidilutive.
Note 6. Sale of Buildings
On February 28, 2013, the Company completed the sale of its manufacturing facility in Chicopee, Massachusetts for proceeds of $3,496,000, net of closing costs and commissions, and recorded a loss on the sale of $31,000. The Company has $177,000 and $785,000 accrued in accounts payable and accrued expenses as of June 30, 2014 and December 31, 2013, respectively, for certain environmental remediation costs related to the sale of this facility. The Company has leased back a reduced portion of the square footage for ongoing golf ball operations.
Note 7. Inventories
Inventories are summarized below (in thousands):
 
June 30,
2014
 
December 31,
2013
Inventories:
 
 
 
Raw materials
$
51,966

 
$
56,104

Work-in-process
423

 
328

Finished goods
156,407

 
207,060

 
$
208,796

 
$
263,492



15


Note 8. Goodwill and Intangibles Assets
Goodwill at June 30, 2014 and December 31, 2013 was $29,367,000 and $29,212,000, respectively. The increase in goodwill during the six months ended June 30, 2014 of $155,000 was due to foreign currency fluctuations. Gross goodwill before impairments at June 30, 2014 and December 31, 2013 was $31,116,000 and $30,961,000, respectively.
The Company’s goodwill and acquired intangible assets with indefinite lives are not amortized, but are subject to an annual impairment test. The Company performs an impairment analysis on its goodwill and intangible assets at least annually and whenever events or changes in circumstances indicate that the carrying value of such assets may not be fully recoverable. Acquired intangible assets with definite lives are amortized over their estimated useful lives and are tested for impairment only when impairment indicators are present.
The following sets forth the intangible assets by major asset class (dollars in thousands):
 
Useful
Life
(Years)
 
June 30, 2014
 
December 31, 2013
 
Gross
 
Accumulated
Amortization
 
Net Book
Value
 
Gross
 
Accumulated
Amortization
 
Net Book
Value
Non-Amortizing:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Trade name, trademark and trade dress and other
NA
 
$
88,590

 
 
$

 
 
$
88,590

 
$
88,590

 
 
$

 
 
$
88,590

Amortizing:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Patents
2-16
 
31,581

 
 
31,313

 
 
268

 
31,581

 
 
31,287

 
 
294

Developed technology and other
1-9
 
7,961

 
 
7,953

 
 
8

 
7,961

 
 
7,944

 
 
17

Total intangible assets
 
 
$
128,132

 
 
$
39,266

 
 
$
88,866

 
$
128,132

 
 
$
39,231

 
 
$
88,901

Aggregate amortization expense on intangible assets was approximately $35,000 and $246,000 for the six months ended June 30, 2014 and 2013, respectively.
Amortization expense related to intangible assets at June 30, 2014 in each of the next five fiscal years and beyond is expected to be incurred as follows (in thousands):
Remainder of 2014
$
32

2015
51

2016
51

2017
51

2018
51

2019
40

 
$
276

Note 9. Investments
Investment in TopGolf International, Inc.
The Company owns preferred shares of TopGolf International, Inc. (“TopGolf”), the owner and operator of TopGolf entertainment centers. In connection with this investment, the Company has a preferred partner agreement with TopGolf in which the Company has preferred signage rights, rights as the preferred supplier of golf products used or offered for use at TopGolf facilities at prices no less than those paid by the Company’s customers, preferred retail positioning in the TopGolf retail stores, access to consumer information obtained by TopGolf, and other rights incidental to those listed.
In June 2014, the Company invested an additional $4,522,000 in preferred shares of TopGolf, thereby increasing the Company's total investment as of June 30, 2014 to $42,127,000. The Company’s total ownership interest in TopGolf, including the incremental investments completed in 2014, remains at less than 20%. In addition, the Company does not have the ability to significantly influence the operating and financing activities and policies of TopGolf. Accordingly, the Company’s investment in TopGolf is accounted for at cost in accordance with ASC Topic 325, “Investments—Other,” and is included in other assets in the accompanying consolidated condensed balance sheets as of June 30, 2014 and December 31, 2013.


16


Note 10. Product Warranty
The Company has a stated two-year warranty policy for its golf clubs. The Company’s policy is to accrue the estimated cost of satisfying future warranty claims at the time the sale is recorded. In estimating its future warranty obligations, the Company considers various relevant factors, including the Company’s stated warranty policies and practices, the historical frequency of claims, and the cost to replace or repair its products under warranty.
The following table provides a reconciliation of the activity related to the Company’s reserve for accrued warranty expense (in thousands):
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2014
 
2013
 
2014
 
2013
Beginning balance
$
7,945

 
$
7,887

 
$
6,406

 
$
7,539

Provision
1,045

 
2,310

 
3,910

 
4,145

Claims paid/costs incurred
(1,594
)
 
(1,956
)
 
(2,920
)
 
(3,443
)
Ending balance
$
7,396

 
$
8,241

 
$
7,396

 
$
8,241

Note 11. Income Taxes
The Company calculates its interim income tax provision in accordance with ASC 270, “Interim Reporting,” and ASC 740 “Accounting for Income Taxes” (together, “ASC 740”). In general, at the end of each interim period, the Company estimates the annual effective tax rate for foreign operations and applies that rate to its ordinary foreign quarterly earnings. For the six months ended June 30, 2014, and consistent with prior quarters, the discrete method was used to calculate the Company's U.S. interim tax expense as the annual effective rate was not considered a reliable estimate of year-to-date income tax expense. Under the discrete method, the Company determines its U.S. tax expense based upon actual results as if the interim period were an annual period. The Company's full U.S. valuation allowance position and the seasonality of the Company's business create results with significant variations in the customary relationship between income tax expense and pre-tax income for the interim periods. As a result, the use of the discrete method is more appropriate than the annual effective tax rate method.
The realization of deferred tax assets, including loss and credit carry forwards, is subject to the Company generating sufficient taxable income during the periods in which the temporary differences become realizable. Due to the Company's taxable losses in the United States over the last few years, the Company has recorded a valuation allowance against its U.S. deferred tax assets. At each quarter end that a valuation allowance is maintained, as the U.S. deferred tax assets are adjusted upwards or downwards, the associated valuation allowance and income tax expense will be adjusted. If sufficient positive evidence arises in the future, such as a sustained return to profitability in the U.S. business, any existing valuation allowance could be reversed as appropriate, decreasing income tax expense in the period that such conclusion is reached.
The provision for income taxes is primarily comprised of taxes related to the Company's foreign operations. The income tax provision for the three months ended June 30, 2014 and 2013 was $1,873,000 and $1,435,000, respectively, and was $3,347,000 and $3,904,000 for the six months ended June 30, 2014 and 2013, respectively. The increase in the income tax provision was primarily due to the release of certain unrecognized tax benefits due to the lapse of statutes of limitation in the second quarter of 2013.
At June 30, 2014, the gross liability for income taxes associated with uncertain tax positions was $11,159,000. The liability for uncertain tax positions could be reduced by $2,240,000 of offsetting tax benefits associated with the correlative effects of potential transfer pricing adjustments as well as $6,921,000 of deferred taxes. The net amount of $1,998,000, if recognized, would favorably affect the Company’s consolidated condensed financial statements and effective income tax rate. The unrecognized tax benefit liabilities are expected to decrease approximately $1,494,000 during the next 12 months. During the second quarter of 2014, the liability for uncertain tax positions was reduced by $27,000 as a result of the lapse of statutes of limitations for certain foreign countries.
The Company recognizes interest and penalties related to income tax matters in income tax expense. For the three months ended June 30, 2014 and 2013, the Company's provision for income taxes includes expense of $64,000 and a benefit of $443,000, respectively. For the six months ended June 30, 2014 and 2013, the Company's provision for income taxes includes benefits of $23,000 and $180,000, respectively. As of June 30, 2014 and December 31, 2013, the gross amount of accrued interest and penalties


17


included in income taxes payable in the accompanying consolidated condensed balance sheets was $1,139,000 and $1,163,000, respectively.
The Company files income tax returns in the U.S. federal jurisdiction and various states and foreign jurisdictions. The Company is generally no longer subject to income tax examinations by tax authorities in the following major jurisdictions:
Tax Jurisdiction
Years No Longer Subject to Audit
U.S. federal
2009 and prior
California (United States)
2008 and prior
Canada
2006 and prior
Japan
2007 and prior
South Korea
2008 and prior
United Kingdom
2009 and prior
Pursuant to Section 382 of the Internal Revenue Code, use of the Company's NOL and credit carry-forwards may be limited significantly if the Company were to experience a cumulative change in ownership of the Company's stock by “5-percent shareholders” that exceeds 50% over a rolling three-year period. The Company does not believe there has been a cumulative change in ownership in excess of 50% during that period. The Company continues to monitor changes in ownership. If such a cumulative change did occur in any three year period and the Company was limited in the amount of losses it could use to offset taxable income, the Company's results of operations and cash flows would be adversely impacted.
Note 12. Commitments & Contingencies
Legal Matters
The Company is subject to routine legal claims, proceedings, and investigations incident to its business activities, including claims, proceedings, and investigations relating to commercial disputes and employment matters. The Company also receives from time to time information claiming that products sold by the Company infringe or may infringe patent, trademark, or other intellectual property rights of third parties. One or more such claims of potential infringement could lead to litigation, the need to obtain licenses, the need to alter a product to avoid infringement, a settlement or judgment, or some other action or material loss by the Company, which also could adversely affect the Company’s overall ability to protect its product designs and ultimately limit its future success in the marketplace. In addition, the Company is occasionally subject to non-routine claims, proceedings, or investigations.
The Company regularly assesses such matters to determine the degree of probability that the Company will incur a material loss as a result of such matters as well as the range of possible loss. An estimated loss contingency is accrued in the Company’s financial statements if it is probable the Company will incur a loss and the amount of the loss can be reasonably estimated. The Company reviews all claims, proceedings, and investigations at least quarterly and establishes or adjusts any accruals for such matters to reflect the impact of negotiations, settlements, advice of legal counsel, and other information and events pertaining to a particular matter. All legal costs associated with such matters are expensed as incurred.
Cleveland Golf Litigation. On October 18, 2013, Dunlop Sports Co., Ltd., a Japanese Corporation, and its wholly-owned subsidiary, Roger Cleveland Golf Company, Inc., which sells golf equipment under the Cleveland and Cleveland Golf trademarks (“Cleveland Golf”), filed a complaint against Callaway Golf Company in the United States District Court - Central District of California (Case 8:13-cv-01642). The Complaint alleges that Callaway’s use on its Callaway branded Mack Daddy 2 Wedges of the phrase “Designed by Roger Cleveland” constitutes trademark infringement (and related claims) of Cleveland Golf’s “Cleveland” trademark. The plaintiffs are seeking equitable relief, disgorgement of profits and injunctive relief. Roger Cleveland has been an employee of Callaway since 1996 and has been designing golf clubs for Callaway for over 17 years. In July 2014, the parties settled this matter pursuant to the terms of a confidential settlement. The terms of the settlement agreement did not provide for the payment of cash by any party to any other party.
Historically, the claims, proceedings and investigations brought against the Company, individually, and in the aggregate, have not had a material adverse effect upon the consolidated results of operations, cash flows, or financial position of the Company. The Company believes that it has valid legal defenses to the matters currently pending against the Company. These matters are inherently unpredictable and the resolutions of these matters are subject to many uncertainties and the outcomes are not predictable


18


with assurance. Consequently, management is unable to estimate the ultimate aggregate amount of monetary loss, amounts covered by insurance, or the financial impact that will result from such matters. Management believes that the final resolution of the current matters pending against the Company, individually and in the aggregate, will not have a material adverse effect upon the Company’s consolidated financial position. The Company’s results of operations or cash flows, however, could be materially affected in any particular period by the unfavorable resolution of one or more of these contingencies.
Unconditional Purchase Obligations
During the normal course of its business, the Company enters into agreements to purchase goods and services, including purchase commitments for production materials, endorsement agreements with professional golfers and other endorsers, employment and consulting agreements, and intellectual property licensing agreements pursuant to which the Company is required to pay royalty fees. It is not possible to determine the amounts the Company will ultimately be required to pay under these agreements as they are subject to many variables including performance-based bonuses, reductions in payment obligations if designated minimum performance criteria are not achieved, and severance arrangements. As of June 30, 2014, the Company has entered into many of these contractual agreements with terms ranging from one to three years. The minimum obligation that the Company is required to pay under these agreements is $57,934,000 over the next three years. In addition, the Company also enters into unconditional purchase obligations with various vendors and suppliers of goods and services in the normal course of operations through purchase orders or other documentation or that are undocumented except for an invoice. Such unconditional purchase obligations are generally outstanding for periods less than a year and are settled by cash payments upon delivery of goods and services and are not reflected in this total. Future minimum purchase commitments as of June 30, 2014, are as follows (in thousands):
Remainder of 2014
$
41,240

2015
12,710

2016
3,795

2017
189

 
$
57,934

Other Contingent Contractual Obligations
During its normal course of business, the Company has made certain indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. These include (i) intellectual property indemnities to the Company’s customers and licensees in connection with the use, sale and/or license of Company product or trademarks, (ii) indemnities to various lessors in connection with facility leases for certain claims arising from such facilities or leases, (iii) indemnities to vendors and service providers pertaining to the goods and services provided to the Company or based on the negligence or willful misconduct of the Company and (iv) indemnities involving the accuracy of representations and warranties in certain contracts. In addition, the Company has consulting agreements that provide for payment of nominal fees upon the issuance of patents and/or the commercialization of research results. The Company has also issued guarantees in the form of standby letters of credit of $1,326,000 as of June 30, 2014.
The duration of these indemnities, commitments and guarantees varies, and in certain cases, may be indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation on the maximum amount of future payments the Company could be obligated to make. Historically, costs incurred to settle claims related to indemnities have not been material to the Company’s financial position, results of operations or cash flows. In addition, the Company believes the likelihood is remote that material payments under the commitments and guarantees described above will have a material effect on the Company’s financial condition. The fair value of indemnities, commitments and guarantees that the Company issued during the six months ended June 30, 2014 was not material to the Company’s financial position, results of operations or cash flows.
Employment Contracts
The Company has made contractual commitments to each of its officers and certain other employees providing for severance payments, including salary continuation, upon the termination of employment by the Company for convenience or by the officer for substantial cause. In addition, in order to assure that the officers would continue to provide independent leadership consistent with the Company’s best interest, the contracts also generally provide for certain protections in the event of a change in control of the Company. These protections include the payment of certain severance benefits, such as salary continuation, upon the termination of employment following a change in control.


19


Note 13. Share-Based Employee Compensation
As of June 30, 2014, the Company had two shareholder approved stock plans under which shares were available for equity-based awards: the Callaway Golf Company Amended and Restated 2004 Incentive Plan and the 2013 Non-Employee Directors Stock Incentive Director Plan. From time to time, the Company grants stock options, restricted stock units, phantom stock units, stock appreciation rights and other awards under these plans. In 2014, the Company granted restricted stock units and performance share units under these plans, compared to stock options and restricted stock units in 2013.
The table below summarizes the amounts recognized in the financial statements for the three and six months ended June 30, 2014 and 2013 for share-based compensation, including expense for stock options, restricted stock units, phantom stock units, cash settled stock appreciation rights and performance share units. The increase in share-based compensation expense during the first six months of 2014 compared to the same period in the prior year was due to a 26% increase in the Company's stock price period over period, which increased the remeasured value of cash-settled awards as of June 30, 2014 compared to June 30, 2013. The decrease in share-based compensation expense in the second quarter of 2014 compared to the same period in the prior year was due to a 19% decrease in the Company's stock during the quarter, which decreased the remeasured value of cash-settled awards as of June 30, 2014 resulting in a reversal of compensation expense.
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
(In thousands)
2014
 
2013
 
2014
 
2013
Cost of sales
$
(183
)
 
$
65

 
$
126

 
$
145

Operating expenses
(2,071
)
 
986

 
2,955

 
2,225

Total cost of share-based compensation included in income,
before income tax
$
(2,254
)
 
$
1,051

 
$
3,081

 
$
2,370

Stock Options
There were no stock options granted during the first six months of 2014. During the three and six months ended June 30, 2013, the Company granted 59,000 and 1,843,000 shares underlying stock options, respectively, at a weighted average grant-date fair value of $2.84 and $2.47 per share, respectively, based on the Black Scholes option-pricing model. Total compensation expense recognized for stock options during the three and six months ended June 30, 2014 was $343,000 and $722,000, respectively. Total compensation expense recognized for stock options during the three and six months ended June 30, 2013 was $469,000 and $848,000, respectively.
The Company records compensation expense for employee stock options based on the estimated fair value of the options on the date of grant using the Black-Scholes option-pricing model. The model uses various assumptions, including a risk-free interest rate, the expected term of the options, the expected stock price volatility, and the expected dividend yield. Compensation expense for employee stock options is recognized over the vesting term and is reduced by an estimate for forfeitures, which is based on the Company’s historical forfeitures of unvested options and awards. The table below summarizes the weighted average Black-Scholes fair value assumptions used in the valuation of stock options granted during the three and six months ended June 30, 2013. There were no stock options granted during the first six months of 2014.
 
Three Months Ended June 30, 2013
 
Six Months Ended 
 June 30, 2013
Dividend yield
0.6
%
 
0.6
%
Expected volatility
49.1
%
 
48.8
%
Risk free interest rate
1.0
%
 
0.7
%
Expected life
5.0 years

 
4.3 years

Restricted Stock Units
Restricted stock units are recorded at the Company’s closing stock price on the date of grant and generally vest at the end of a three year period. During the three and six months ended June 30, 2014, the Company granted 47,000 and 412,000 shares underlying restricted stock units, respectively, at a weighted average grant-date fair value of $8.66 and $8.23 per share, respectively. Total compensation expense, net of estimated forfeitures, recognized for restricted stock units during the three and six months ended June 30, 2014 was $753,000 and $1,350,000, respectively.


20


During the three and six months ended June 30, 2013, the Company granted 72,000 and 441,000 shares underlying restricted stock units, respectively, at a weighted average grant-date fair value of $6.69 and $6.55 per share, respectively. Total compensation expense, net of estimated forfeitures, recognized for restricted stock units during the three and six months ended June 30, 2013 was $443,000 and $822,000, respectively.
At June 30, 2014, the Company had $5,440,000 of total unrecognized compensation expense related to non-vested restricted stock units under the Company’s share-based payment plans. That cost is expected to be recognized over a weighted-average period of 1.9 years.
Performance Share Units
Performance share units are a form of stock-based awards in which the number of shares ultimately received depends on the Company's performance against specified metrics that are measured over a one year performance period from the date of grant. These performance metrics were established by the Company at the beginning of the performance period. At the end of the performance period, the number of shares of stock that could be issued will be fixed based upon the degree of achievement of the performance goals. The number of shares that could be issued can range from 50% to 150% of the participant's target award. If the performance metrics are not met at the end of the performance period, compensation expense would be reversed and the awards would be forfeited. The performance units vest in full at the end of a three year period.
The Company granted 7,000 and 453,000 performance share units during the three and six months ended June 30, 2014, respectively, at a weighted average grant-date fair value of $10.34 and $8.20 per share, respectively. There were no performance share units granted in 2013. During the three and six months ended June 30, 2014, the Company recognized total compensation expense, net of estimated forfeitures, of $279,000 and $467,000, respectively.
Phantom Stock Units
Phantom stock units ("PSUs") are a form of share-based awards that are indexed to the Company’s stock and are settled in cash. Because PSUs are settled in cash, compensation expense recognized over the vesting period will vary based on changes in fair value. Fair value is remeasured at the end of each interim reporting period based on the closing price of the Company’s stock. PSUs vest at the end of a three year period.
There were no PSUs granted in the first six months of 2014 and 2013. The Company reversed $139,000 and recognized $433,000 of compensation expense related to previously granted PSUs during the three and six months ended June 30, 2014, respectively, and recognized $252,000 and $517,000 in compensation expense during the three and six months ended June 30, 2013, respectively.
At June 30, 2014, accrued compensation expense for PSUs was $1,682,000, which was recorded in accrued employee compensation and benefits in the accompanying consolidated condensed balance sheets. At December 31, 2013, the Company accrued $2,830,000 of compensation expense for PSUs, of which $1,439,000 was included in accrued employee compensation and benefits and $1,391,000 was included in long-term incentive compensation and other in the accompanying consolidated condensed balance sheets.
Stock Appreciation Rights
The Company records compensation expense for cash settled stock appreciation rights (“SARs”) based on the estimated fair value on the date of grant using the Black Scholes option-pricing model. SARs are subsequently remeasured at each interim reporting period based on a revised Black Scholes value until they are exercised. SARs vest over a three year period.
There were no SARs granted during the first six months of 2014 and 2013. The Company reversed $3,490,000 and $114,000 in compensation expense for SARs during the three months ended June 30, 2014 and 2013, respectively, and recognized $109,000 and $182,000 in compensation expense for SARs during the six months ended June 30, 2014 and 2013, respectively.
At June 30, 2014, the Company accrued compensation expense of $5,257,000 in accrued employee compensation and benefits in the accompanying consolidated condensed balance sheets. At December 31, 2013, the Company accrued compensation expense of $5,193,000, of which $4,200,000 and $993,000 was included in accrued employee compensation and benefits and long-term incentive compensation and other, respectively, in the accompanying consolidated condensed balance sheets.


21


Note 14. Fair Value of Financial Instruments
Certain of the Company’s financial assets and liabilities are measured at fair value on a recurring and nonrecurring basis. Fair value is defined as the price that would be received to sell an asset or the price paid to transfer a liability (the exit price) in the principal and most advantageous market for the asset or liability in an orderly transaction between market participants. Assets and liabilities carried at fair value are classified using the following three-tier hierarchy:
Level 1: Quoted market prices in active markets for identical assets or liabilities;
Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which significant inputs and significant value drivers are observable in active markets; and
Level 3: Fair value measurements derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.
The following table summarizes the valuation of the Company’s foreign currency exchange contracts (see Note 15) that are measured at fair value on a recurring basis by the above pricing levels at June 30, 2014 and December 31, 2013 (in thousands):
 
Fair
Value
 
Level 1
 
Level 2
 
Level 3
June 30, 2014
 
 
 
 
 
 
 
Foreign currency derivative instruments—asset position
$
526

 
$

 
$
526

 
$

Foreign currency derivative instruments—liability position
(3,252
)
 

 
(3,252
)
 

 
$
(2,726
)
 
$

 
$
(2,726
)
 
$

December 31, 2013
 
 
 
 
 
 
 
Foreign currency derivative instruments—asset position
$
557

 
$

 
$
557

 
$

Foreign currency derivative instruments—liability position
(823
)
 

 
(823
)
 

 
$
(266
)
 
$

 
$
(266
)
 
$

The fair value of the Company’s foreign currency exchange contracts is based on observable inputs that are corroborated by market data. Foreign currency derivatives on the balance sheet are recorded at fair value with changes in fair value recorded in the statements of operations.
Disclosures about the Fair Value of Financial Instruments
The carrying values of cash and cash equivalents, trade accounts receivable and trade accounts payable at June 30, 2014 and December 31, 2013 are reasonable estimates of fair value due to the short-term nature of these balances. The table below illustrates information about fair value relating to the Company’s financial assets and liabilities that are recognized on the accompanying consolidated condensed balance sheets as of June 30, 2014 and December 31, 2013, as well as the fair value of contingent contracts that represent financial instruments (in thousands).
 
June 30, 2014
 
December 31, 2013
 
Carrying
Value
 
Fair
Value
 
Carrying
Value
 
Fair 
Value
Convertible notes(1)
$
108,200

 
$
138,375

 
$
107,835

 
$
138,668

ABL Facility(2)
$
60,206

 
$
60,206

 
$
25,660

 
$
25,660

Standby letters of credit(3)
$
1,326

 
$
1,326

 
$
1,297

 
$
1,297

 
(1)
The carrying value of the convertible notes at June 30, 2014 and December 31, 2013, is net of the unamortized discount of $4,300,000 and $4,665,000, respectively (see Note 3). The fair value of the convertible notes was determined based on secondary quoted market prices, and as such is classified as Level 2 in the fair value hierarchy.
(2)
The carrying value of amounts outstanding under the Company's ABL Facility approximate the fair value due to the short term nature of this obligation. The fair value of this debt is categorized within Level 2 of the fair value hierarchy.


22


(3)
The carrying value of amounts outstanding under the Company's standby letters of credit approximates the fair value as they represent the Company’s contingent obligation to perform in accordance with the underlying contracts. The fair value of this contingent obligation is categorized within Level 2 of the fair value hierarchy.
Nonrecurring Fair Value Measurements
The Company measures certain assets at fair value on a nonrecurring basis when certain indicators are present. These assets include property, plant and equipment, goodwill and non-amortizing intangible assets that are written down to fair value when they are held for sale or determined to be impaired. During the six months ended June 30, 2014 and 2013, the Company did not have any significant assets or liabilities that were measured at fair value on a nonrecurring basis in periods subsequent to initial recognition.
Note 15. Derivatives and Hedging
Foreign Currency Exchange Contracts
The Company accounts for its foreign currency exchange contracts in accordance with ASC Topic 815, “Derivatives and Hedging” (“ASC 815”). ASC 815 requires the recognition of all derivatives as either assets or liabilities on the balance sheet, the measurement of those instruments at fair value and the recognition of changes in the fair value of derivatives in earnings in the period of change, unless the derivative qualifies as an effective hedge that offsets certain exposures.
In the normal course of business, the Company is exposed to gains and losses resulting from fluctuations in foreign currency exchange rates relating to transactions of its international subsidiaries, including certain balance sheet exposures (payables and receivables denominated in foreign currencies). In addition, the Company is exposed to gains and losses resulting from the translation of the operating results of the Company’s international subsidiaries into U.S. dollars for financial reporting purposes. As part of its strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates, the Company uses derivative financial instruments in the form of foreign currency forward contracts and put and call option contracts (“foreign currency exchange contracts”) to help mitigate transactions that are denominated primarily in Japanese Yen, British Pounds, Euros, Canadian Dollars, Australian Dollars and Korean Won. Foreign currency exchange contracts are used only to meet the Company’s objectives of minimizing variability in the Company’s operating results arising from foreign exchange rate movements. The Company does not enter into foreign currency exchange contracts for speculative purposes. Foreign currency exchange contracts usually mature within twelve months from their inception.
The Company did not designate any foreign currency exchange contracts as derivatives that qualify for hedge accounting under ASC 815. At June 30, 2014 and December 31, 2013, the notional amounts of the Company’s foreign currency exchange contracts used to help mitigate the exposures discussed above were approximately $167,894,000 and $42,264,000, respectively. The increase in foreign currency exchange contracts reflects the general timing of when the Company enters into these contracts. The Company estimates the fair values of foreign currency exchange contracts based on pricing models using current market rates, and records all derivatives on the balance sheet at fair value with changes in fair value recorded in the statements of operations. The foreign currency contracts are classified under Level 2 of the fair value hierarchy (see Note 14).
The following table summarizes the fair value of derivative instruments by contract type as well as the location of the asset and/or liability on the consolidated condensed balance sheets at June 30, 2014 and December 31, 2013 (in thousands):
Derivatives not designated as hedging instruments
Asset Derivatives
June 30, 2014
 
December 31, 2013
Balance Sheet Location
 
Fair Value
 
Balance Sheet Location
 
Fair Value
Foreign currency exchange contracts
Other current assets
 
$
526

 
Other current assets
 
$
557

Derivatives not designated as hedging instruments
Liability Derivatives
June 30, 2014
 
December 31, 2013
Balance Sheet Location
 
Fair Value
 
Balance Sheet Location
 
Fair Value
Foreign currency exchange contracts
Accounts payable and
accrued expenses
 
$
3,252

 
Accounts payable and
accrued expenses
 
$
823



23


The following table summarizes the location of net gains and losses in the consolidated condensed statements of operations that were recognized during the three and six months ended June 30, 2014 and 2013, respectively, in addition to the derivative contract type (in thousands):
  
Location of net gain (loss) recognized in income on 
derivative instruments
 
Amount of Net Gain (Loss) Recognized in
Income on Derivative Instruments
Derivatives not designated as hedging instruments
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
2014
 
2013
 
2014
 
2013
Foreign currency exchange contracts
Other (expense) income, net
 
$
(4,670
)
 
$
4,956

 
$
(7,602
)
 
$
12,803

The amounts shown in the table above represent a combination of realized and unrealized net gains and losses that were recognized by the Company on its foreign currency exchange contracts during the second quarter and first half of 2014 and 2013. Unrealized gains and losses represent the remeasurement of foreign currency exchange contracts that will mature in future periods. In addition, during the second quarter of 2014 and 2013, the Company recognized net foreign currency gains of $1,649,000 and net foreign currency losses of $2,530,000, respectively, related to transactions with foreign subsidiaries. During the first half of 2014 and 2013, the Company recognized net foreign currency gains of $2,368,000 and net foreign currency losses of $4,307,000, respectively, related to transactions with foreign subsidiaries.
Note 16. Segment Information
The Company has two operating segments that are organized on the basis of products, namely the golf clubs segment and golf balls segment. The golf clubs segment consists of Callaway Golf woods, hybrids, irons and wedges and Odyssey putters. This segment also includes golf apparel and footwear, golf bags, golf gloves, travel gear, headwear and other golf-related accessories, in addition to royalties from licensing of the Company’s trademarks and service marks and sales of pre-owned golf clubs. The golf balls segment consists of Callaway Golf balls that are designed, manufactured and sold by the Company. There are no significant intersegment transactions.
The table below contains information utilized by management to evaluate its operating segments for the interim periods presented (in thousands):
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2014
 
2013(1)
 
2014
 
2013(1)
Net sales:
 
 
 
 
 
 
 
Golf Clubs
$
193,159

 
$
206,857

 
$
492,323

 
$
452,226

Golf Balls
38,734

 
42,789

 
91,444

 
85,176

 
$
231,893

 
$
249,646

 
$
583,767

 
$
537,402

Income before income taxes:
 
 
 
 
 
 
 
Golf Clubs (2)
$
11,280

 
$
24,272

 
$
74,017

 
$
69,030

Golf Balls (2)
5,223

 
(2,731
)
 
16,952

 
2,687

Reconciling items(3)
(11,261
)
 
(10,035
)
 
(28,941
)
 
(16,082
)
 
$
5,242

 
$
11,506

 
$
62,028

 
$
55,635

Additions to long-lived assets:
 
 
 
 
 
 
 
Golf Clubs
$
2,317

 
$
2,827

 
$
5,232

 
$
6,433

Golf Balls

 
17

 
101

 
28

 
$
2,317

 
$
2,844

 
$
5,333

 
$
6,461

 
(1)
The prior year amounts have been restated to reflect the Company's current year allocation methodology related to freight revenue and costs, certain discounts and other reserves not specific to a product type. For the three months ended June 30, 2013, this resulted in increases to net sales and income before income taxes of $639,000 and $3,441,000, respectively, in the golf clubs segment, and corresponding decreases in net sales and income before income taxes in the golf balls segment. For the six months ended June 30, 2013, this resulted in increases in net sales and income before income taxes of $1,237,000 and


24


$4,209,000, respectively, in the golf clubs segment, and corresponding decreases in net sales and income before income taxes in the golf balls segment.
(2)
In connection with the Cost Reduction Initiatives (see Note 2), the Company’s golf clubs and golf balls segments recognized pre-tax charges of $572,000 and $4,112,000, respectively during the three months ended June 30, 2013, and $3,272,000 and $4,228,000, respectively, during the six months ended June 30, 2013.
(3)
Reconciling items represent corporate general and administrative expenses and other income (expense) not included by management in determining segment profitability. The increase in reconciling items in the second quarter and first six months of 2014 compared to the second quarter and first six months of 2013 was due to the recognition of net losses on foreign currency exchange contracts in 2014 compared to the recognition of net gains on these contracts in 2013. During the three and six months ended June 30, 2013, the reconciling items include pre-tax charges of $314,000 and $1,007,000, respectively, in connection with the Cost Reduction Initiatives.


25


Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the Consolidated Condensed Financial Statements and the related notes that appear elsewhere in this report. See also “Important Notice to Investors Regarding Forward-Looking Statements” on page 2 of this report.
Results of Operations
Overview of Business and Seasonality
The Company designs, manufactures and sells high quality golf clubs and golf balls and also sells golf apparel, golf footwear, golf bags, gloves, eyewear and other golf-related accessories. The Company designs its products to be technologically advanced and in this regard invests a considerable amount in research and development each year. The Company’s golf products are designed for golfers of all skill levels, both amateur and professional.
The Company has two operating segments that are organized on the basis of products, namely the golf clubs segment and golf balls segment. The golf clubs segment consists of Callaway Golf woods, hybrids, irons and wedges and Odyssey putters. This segment also includes other golf-related accessories described above and royalties from licensing of the Company’s trademarks and service marks as well as sales of pre-owned golf clubs. The golf balls segment consists of Callaway Golf balls that are designed, manufactured and sold by the Company. As discussed in Note 16 “Segment Information” to the Notes to Consolidated Condensed Financial Statements, the Company’s operating segments exclude a significant amount of corporate general administrative expenses and other income (expense) not utilized by management in determining segment profitability.
The Company’s cost of sales is comprised primarily of material and component costs, distribution and warehousing costs, and overhead. Due to the recent actions taken in connection with the Cost Reduction Initiatives to improve manufacturing efficiencies, a greater percentage of the company's manufacturing costs became variable in nature and will fluctuate with sales volumes. With respect to the Company's operating segments, variable costs for golf clubs represent approximately 85% to 95% of cost of sales, and for golf balls, approximately 75% to 85%. Of these variable costs, material and component costs represent approximately 85% to 95% for golf clubs and approximately 75% to 85% for golf balls. On a consolidated basis, over 85% of total cost of sales is variable in nature, and of this amount, over 85% is comprised of material and component costs. Generally, the relative significance of the components of costs of sales does not vary materially from these percentages.
In most of the regions where the Company does business, the game of golf is played primarily on a seasonal basis. Weather conditions generally restrict golf from being played year-round, except in a few markets, with many of the Company’s on-course customers closing for the cold weather months. The Company’s business is therefore subject to seasonal fluctuations. In general, during the first quarter, the Company begins selling its products into the golf retail channel for the new golf season. This initial sell-in generally continues into the second quarter. The Company’s second quarter sales are significantly affected by the amount of reorder business of the products sold during the first quarter. The Company’s third quarter sales are generally dependent on reorder business but are generally less than the second quarter as many retailers begin decreasing their inventory levels in anticipation of the end of the golf season. The Company’s fourth quarter sales are generally less than the other quarters due to the end of the golf season in many of the Company’s key markets. However, fourth quarter sales can be affected from time to time by the early launch of product introductions related to the new golf season of the subsequent year. This seasonality, and therefore quarter to quarter fluctuations, can be affected by many factors, including the timing of new product introductions as well as weather conditions. In general, however, because of this seasonality, a majority of the Company’s sales and most, if not all, of its profitability generally occurs during the first half of the year.
A significant portion of the Company’s business is conducted outside of the United States and is conducted in currencies other than the U.S. dollar. As a result, changes in foreign currency rates can have a significant effect on the Company’s financial results. The Company enters into foreign currency exchange contracts to mitigate the effects of changes in foreign currency rates. While these foreign currency exchange contracts can mitigate the effects of changes in foreign currency rates, they do not eliminate those effects, which can be significant. These effects include (i) the translation of results denominated in foreign currency into U.S. dollars for reporting purposes, (ii) the mark-to-market adjustments of certain intercompany balance sheet accounts denominated in foreign currencies, and (iii) the mark-to-market adjustments on the Company’s foreign currency exchange contracts. In general, the Company’s overall financial results are affected positively by a weaker U.S. dollar and are affected negatively by a stronger U.S. dollar as compared to the foreign currencies in which the Company conducts its business. The Company’s reported net sales in regions outside the U.S. in the first half of 2014 were negatively affected by the translation of foreign currency sales into U.S. dollars based on 2014 exchange rates. If exchange rates for the first half of 2013 were applied to 2014 reported sales in


26


regions outside the U.S. and all other factors were held constant, net sales in such regions would have been $4.7 million higher than the net sales reported in the first half of 2014.
Executive Summary
The Company’s net sales for the first six months of 2014 increased to $583.8 million or 9%, as compared to $537.4 million for the same period in 2013.  This year-to-date increase was driven by the Company’s continued brand momentum and the strength of its 2014 product line, which resulted in a significant increase in all product categories and market share gains in each of the Company’s key markets around the world. The first half sales reflect both a 22% increase in net sales in the first quarter as well as a 7% decrease in sales in the second quarter. The second quarter net sales were adversely affected by challenging market conditions, including a late start to the 2014 golf season, high retail inventory industrywide and increased promotional activity compared to the second quarter of 2013.
The Company’s gross profit as a percentage of sales increased 170 basis points during the first half of 2014 and by 90 basis points for the second quarter of 2014, both as compared to the same periods in the prior year. These increases were primarily the result of the improved manufacturing and distribution efficiencies resulting from the Company’s prior cost-reduction initiatives. Also contributing to the increase for the first six months of 2014 was an increase in sales of higher margin products compared to 2013. In addition, there were no charges related to the Cost Reduction Initiatives in 2014 compared to charges incurred in 2013 of $4.1 million in the second quarter and $6.4 million in the first six months.
During the first six months of 2014, the Company continued to manage operating expenses while also increasing its investment in its marketing and tour programs. As a result, as planned, operating expenses increased by $8.7 million for the first six months of 2014 compared to the first six months of 2013. Operating expenses for the second quarter of 2014 decreased by $4.2 million, primarily as a result of a decrease in stock compensation resulting from the remeasurement of cash-settled awards.
For the first six months of 2014, the Company’s other income/expense decreased to other expense of $5.2 million compared to other income of $8.7 million in the first six months of 2013. For the second quarter of 2014, the Company’s other income/expense decreased by $5.5 million to other expense of $3.0 million compared to other income of $2.5 million in the second quarter of 2013. The decreases for both periods were primarily attributable to unfavorable changes in foreign currency rates related to the remeasurement of outstanding foreign currency hedging contracts.
For the first six months of 2014, net income increased by $7.0 million or 13%, and earnings per share increased by $0.07 or 12%, as compared to the same period in 2013. For the second quarter of 2014, net income decreased by $6.7 million or 67%, and earnings per share decreased by $0.08 or 67%, as compared to the second quarter of 2013. Management anticipates that market conditions will remain challenging for the second half of the year, but also believes that the Company’s brand momentum and continually improving operational efficiencies should mitigate these headwinds and permit the Company to return to profitability for the full year.
Three-Month Periods Ended June 30, 2014 and 2013
Net sales for the second quarter of 2014 decreased by $17.7 million to $231.9 million compared to $249.6 million in the second quarter of 2013. This decrease was due to the late start to the 2014 golf season, high retail inventory industry-wide and increased promotional activity compared to the same period in 2013. Despite the softer than expected market conditions, the Company managed to gain market share due to continued brand momentum and the strong performance of the Big Bertha drivers, APEX irons and Speed Regime and Supersoft golf balls launched during the current year. Additionally, sales were positively impacted by favorable fluctuations in foreign currency rates during the second quarter of 2014. If 2013 rates were applied to 2014 sales in regions outside the U.S., net sales would have been $1.7 million lower.


27


The Company’s net sales by operating segment are presented below (dollars in millions):
 
Three Months Ended 
 June 30,
 
Decline
 
2014
 
2013 (1)
 
Dollars
 
Percent
Net sales:
 
 
 
 
 
 
 
Golf clubs
$
193.2

 
$
206.8

 
$
(13.6
)
 
(7
)%
Golf balls
38.7

 
42.8

 
(4.1
)
 
(10
)%
 
$
231.9

 
$
249.6

 
$
(17.7
)
 
(7
)%
 
(1) The prior year amounts have been restated to reflect the Company's current year allocation methodology related to freight revenue and costs, certain discounts and other reserves not specific to a product type. This resulted in an increase to net sales of $0.6 million in the golf clubs segment, and a corresponding decrease in net sales in the golf balls segment.

For further discussion of each operating segment’s results, see "Golf Clubs and Golf Balls Segments" results below.
Net sales information by region is summarized as follows (dollars in millions):
 
Three Months Ended 
 June 30,
 
Growth/(Decline)
 
2014
 
2013
 
Dollars
 
Percent
Net sales:
 
 
 
 
 
 
 
United States
$
112.5

 
$
124.4

 
$
(11.9
)
 
(10
)%
Europe
39.3

 
40.2

 
(0.9
)
 
(2
)%
Japan
32.5

 
36.7

 
(4.2
)
 
(11
)%
Rest of Asia
25.1

 
22.9

 
2.2

 
10
 %
Other countries
22.5

 
25.4

 
(2.9
)
 
(11
)%
 
$
231.9

 
$
249.6

 
$
(17.7
)
 
(7
)%
Net sales in the United States decreased $11.9 million (10%) to $112.5 million during the second quarter of 2014 compared to the same period in the prior year. The Company’s sales in regions outside of the United States decreased $5.9 million (5%) to $119.4 million for the second quarter of 2014 compared to $125.3 million in the same quarter of 2013. The 7% decrease in net sales in all regions primarily resulted from the challenging market conditions and high promotional activity mentioned above. This decrease was partially offset by the favorable impact of the translation of foreign currency sales into U.S. Dollars based upon 2014 exchange rates. If 2013 exchange rates were applied to 2014 reported sales in regions outside the U.S. and all other factors were held constant, net sales in such regions would have been $1.7 million lower than reported in the second quarter of 2014.
Gross profit decreased $4.9 million (5%) to $90.8 million for the second quarter of 2014 compared to $95.7 million in the second quarter of 2013. Gross profit as a percentage of net sales (“gross margin”) increased to 39.2% in the second quarter of 2014 compared to 38.3% in the second quarter of 2013. This increase was primarily due to cost savings from improved manufacturing and distribution efficiencies, and charges recognized during the second quarter of 2013 related to the Cost Reduction Initiatives. These increases were partially offset by (i) the net unfavorable impact of changes in foreign currency rates period over period; (ii) an increase in promotional activity in the second quarter of 2014 compared to the second quarter of 2013; (iii) and an increase in club component costs due to more expensive materials and technology incorporated into certain putters and woods products launched in the current year. See "Cost of Sales and Segment Profitability" below for further discussion of gross margin.
Selling expenses decreased by $1.1 million to $60.6 million (26.1% of net sales) in the second quarter of 2014 compared to $61.7 million (24.7% of net sales) in the comparable period of 2013. This decrease was primarily due to a $0.5 million decrease in marketing expenses in addition to a $0.5 million decrease in employee costs.
General and administrative expenses decreased by $2.7 million to $12.5 million (5.4% of net sales) in the second quarter of 2014 compared to $15.2 million (6.1% of net sales) in the comparable period of 2013. This decrease was primarily due to a $2.6 million decrease in stock compensation expense as a result of a 19% decrease in the Company's stock in the second quarter of 2014, combined with a $1.0 million decrease in legal expenses, partially offset by a $0.7 million increase in bad debt expense.


28


Research and development expenses decreased by $0.5 million to $6.8 million (3.0% of net sales) in the second quarter of 2014 compared to $7.3 million (2.9% of net sales) in the comparable period of 2013. This decrease was primarily due to a decrease in employee costs.
Interest expense increased slightly to $2.9 million in the second quarter of 2014 compared to $2.8 million in the second quarter of 2013.
Other income (expense), net decreased to other expense of $3.0 million in the second quarter of 2014 compared to other income of $2.5 million in the second quarter of 2013. This decrease was primarily due to a $5.5 million increase in net foreign currency losses in the second quarter of 2014 compared to the same period in 2013.
The Company’s provision for income taxes increased to $1.9 million in the second quarter of 2014, compared to $1.4 million in the second quarter of 2013. The $0.5 million increase resulted primarily from the release of certain unrecognized tax benefits during the second quarter of 2013 resulting from the lapse of certain statutes of limitation. Due to the effects of the Company’s valuation allowance against its U.S. deferred tax assets, the Company’s effective tax rate for the second quarter of 2014 is not comparable to the effective tax rate for the second quarter of 2013 as the Company’s provision for income taxes is not directly correlated to the amount of its pretax income.
Net income for the second quarter of 2014 decreased $6.7 million to $3.4 million compared to $10.1 million in the second quarter of 2013. Diluted earnings per share decreased $0.08 to $0.04 in the second quarter of 2014 compared to $0.12 in the second quarter of 2013.
Golf Clubs and Golf Balls Segments Results for the Three Months Ended June 30, 2014 and 2013
Golf Clubs Segment
Net sales information by product category is summarized as follows (dollars in millions):
 
Three Months Ended 
 June 30,
 
Growth/(Decline)
 
2014
 
2013 (1)
 
Dollars
 
Percent

Net sales:
 
 
 
 
 
 
 
Woods
$
52.5

 
$
70.2

 
$
(17.7
)
 
(25
)%
Irons
52.5

 
53.8

 
(1.3
)
 
(2
)%
Putters
26.8

 
21.7

 
5.1

 
24
 %
Accessories and other
61.4

 
61.1

 
0.3

 
 %
 
$
193.2

 
$
206.8

 
$
(13.6
)
 
(7
)%
 
(1) The prior year amounts have been restated to reflect the Company's current year allocation methodology related to freight revenue and costs, certain discounts and other reserves not specific to a product type. This resulted in an increase to net sales of $0.6 million in the golf clubs segment, and a corresponding decrease in net sales in the golf balls segment.
The $17.7 million (25%decrease in net sales of woods to $52.5 million for the quarter ended June 30, 2014 resulted from a decline in both sales volume and average selling prices. The decrease in sales volume was primarily due to a decline in sales of the Company's X2 Hot fairway woods in the second quarter of 2014 compared to the X Hot fairway woods in the second quarter of 2013 (fairway woods were up 57% in the second quarter of 2013 compared to the same period of 2012). The decrease in average selling prices was due to an increase in promotional activity at retail during the second quarter of 2014 compared to the same quarter in the prior year.
The $1.3 million (2%decrease in net sales of irons to $52.5 million for the quarter ended June 30, 2014 was primarily attributable to a decline in sales volume partially offset by an increase in average selling prices. The decrease in sales volume was primarily due to a decline in sales of the X2 Hot irons compared to the prior year X Hot irons resulting from challenging market conditions in the current year. This was partially offset by the strong performance of the Company's APEX irons launched during the current year. The increase in average selling prices was due to a favorable shift in product mix due to the success of the more premium APEX irons in the current year combined with the introduction of the APEX irons at higher average selling prices than the X Forged irons which were launched in the prior year.


29


The $5.1 million (24%) increase in the net sales of putters to $26.8 million for the quarter ended June 30, 2014 was primarily due to an increase in average selling prices combined with a slight increase in sales volumes. The increase in average selling prices was due to a favorable shift in product mix due to increased sales of the Company's new counterbalanced technology putters (Tank and Tank Cruiser) as well as the introduction of the new elite Metal X Milled putter during 2014 with no comparable elite putter launch during the prior year. The increase in sales volume was due to the launch of the new Tank Cruiser adjustable counterbalance line of putters during the second quarter of 2014.
The $0.3 million (0%) increase in net sales of accessories and other to $61.4 million for the quarter ended June 30, 2014 was primarily due to an increase in sales of packaged sets, partially offset by a decline in apparel and footwear sales due to the transition of the Company’s apparel and footwear sales in Europe to a licensing arrangement during the first quarter of 2014.
Golf Balls Segment
Net sales information for the golf balls segment is summarized as follows (dollars in millions):
 
Three Months Ended 
 June 30,
 
Decline
 
2014
 
2013(1)
 
Dollars
 
Percent
Net sales:
 
 
 
 
 
 
 
Golf balls
$
38.7

 
$
42.8

 
$
(4.1
)
 
(10
)%
 
(1) The prior year amounts have been restated to reflect the Company's current year allocation methodology related to freight revenue and costs, certain discounts and other reserves not specific to a product type. This resulted in an increase to net sales of $0.6 million in the golf clubs segment, and a corresponding decrease in net sales in the golf balls segment.
The $4.1 million (10%decrease in net sales of golf balls to $38.7 million for the quarter ended June 30, 2014 was primarily due to a decline in sales volume with a slight increase in average selling prices. The decrease in sales volume was primarily due to a decline in sales of Special Make-Up ("SMU") balls partially offset by the success of the Company's Supersoft and Speed regime golf balls launched during the first quarter of 2014. The increase in average selling prices resulted from a favorable shift in product mix to sales of higher priced Speed Regime golf balls with no comparable premium ball launch in 2013.
Segment Profitability
Profitability by operating segment is summarized as follows (dollars in millions):
 
Three Months Ended 
 June 30,
 
Growth/(Decline)
 
2014
 
2013(1)
 
Dollars
 
Percent
Income before income taxes:
 
 
 
 
 
 
 
Golf clubs(2)
$
11.3

 
$
24.2

 
$
(12.9
)
 
(53
)%
Golf balls(2)
5.2

 
(2.7
)
 
7.9

 
293
 %
Reconciling items(3) 
(11.3
)
 
(10.0
)
 
(1.3
)
 
13
 %
 
$
5.2

 
$
11.5

 
$
(6.3
)
 
(55
)%
 
(1)
The prior year amounts have been restated to reflect the Company's current year allocation methodology related to freight revenue and costs, certain discounts and other reserves not specific to a product type. This resulted in an increase to income before income taxes of $3.4 million in the golf clubs segment, and a corresponding decrease in income before income taxes in the golf balls segment.
(2)
In connection with the Cost Reduction Initiatives (see Note 2 "Cost Reduction Initiatives" to the Notes to Consolidated Condensed Financial Statements), during the three months ended June 30, 2013, the Company’s golf clubs and golf balls segments recognized pre-tax charges of $0.6 million and $4.1 million, respectively.
(3)
Reconciling items represent corporate general and administrative expenses and other income (expense) not included by management in determining segment profitability. For the second quarter of 2013, the reconciling items include pre-tax charges of $0.3 million related to the Cost Reduction Initiatives.


30


Pre-tax income in the Company’s golf clubs operating segment decreased to $11.3 million for the second quarter of 2014 from $24.3 million for the comparable period in the prior year. This decrease was driven by a decrease in net sales as discussed above combined with a decrease in gross profit as a percentage of sales ("gross margin" or "margin"). The decrease in gross margin was primarily due to (i) the net unfavorable impact of changes in foreign currency rates period over period; (ii) an increase in promotional activity in the second quarter of 2014 compared to the second quarter of 2013; (iii) and an increase in club component costs due to more expensive materials and technology incorporated into certain woods and putter products launched in the current year. These decreases were partially offset by cost savings from improved manufacturing and distribution efficiencies, and charges recognized during the second quarter of 2013 related to the Cost Reduction Initiatives.
Pre-tax income in the Company’s golf balls operating segment increased to $5.2 million for the second quarter of 2014 from a loss of $2.7 million for the comparable period in the prior year. This increase was primarily attributable to a 22.8 percentage point improvement in gross margin, partially offset by a decrease in net sales as discussed above. The improvement in gross margin was primarily due to (i) cost savings from improved manufacturing and distribution efficiencies; (ii) charges recognized during the second quarter of 2013 related to the Cost Reduction Initiatives; and (iii) the launch of the premium Speed Regime golf balls in 2014 with no comparable premium launch in 2013. These increases were partially offset by the net unfavorable impact on gross margin resulting from changes in foreign currency rates.
Six-Month Periods Ended June 30, 2014 and 2013
Net sales for the six months ended June 30, 2014 increased $46.4 million to $583.8 million compared to $537.4 million for the same period in 2013. This increase was due to increased sales in both the golf club and golf ball operating segments resulting from continued brand momentum and the strong performance of the Big Bertha drivers, APEX irons, and Speed Regime and Supersoft golf balls launched during the current year. These increases were partially offset by the late start to the 2014 golf season, high retail inventory industry-wide and increased promotional activity during the second quarter of 2014. Additionally, the Company’s net sales for the first six months of 2014 were negatively impacted by $4.7 million resulting from unfavorable fluctuations in foreign currency rates.
The Company’s net sales by operating segment are presented below (dollars in millions):
 
Six Months Ended 
 June 30,
 
Growth
 
2014
 
2013(1)
 
Dollars
 
Percent
Net sales:
 
 
 
 
 
 
 
Golf clubs
$
492.4

 
$
452.2

 
$
40.2

 
9
%
Golf balls
91.4

 
85.2

 
6.2

 
7
%
 
$
583.8

 
537.4

 
46.4

 
9
%
 
(1) The prior year amounts have been restated to reflect the Company's current year allocation methodology related to freight revenue and costs, certain discounts and other reserves not specific to a product type. This resulted in an increase to net sales of $1.2 million in the golf clubs segment, and a corresponding decrease in net sales in the golf balls segment.
For further discussion of each operating segment’s results, see “Golf Clubs and Golf Balls Segments Results” below.
Net sales information by region is summarized as follows (dollars in millions):
 
Six Months Ended 
 June 30,
 
Growth
 
2014
 
2013
 
Dollars
 
Percent
Net sales:
 
 
 
 
 
 
 
United States
$
297.2

 
$
284.1

 
$
13.1

 
5
%
Europe
90.5

 
78.5

 
12.0

 
15
%
Japan
92.5

 
80.8

 
11.7

 
14
%
Rest of Asia
52.1

 
43.0

 
9.1

 
21
%
Other countries
51.5

 
51.0

 
0.5

 
1
%
 
$
583.8

 
$
537.4

 
$
46.4

 
9
%


31


Net sales in the United States increased $13.1 million (5%) to $297.2 million during the six months ended June 30, 2014 compared to the same period in the prior year. The Company’s sales in regions outside of the United States increased $33.3 million (13%) to $286.6 million for the six months ended June 30, 2014 compared to $253.3 million in the same period in 2013. The 9% increase in net sales in all regions resulted from the continued improvement in brand momentum combined with the strong performance of the current year product introductions. This increase was partially offset by challenging market conditions as well as the unfavorable impact of the translation of foreign currency sales into U.S. Dollars based upon 2014 exchange rates. If 2013 exchange rates were applied to 2014 reported sales in regions outside the U.S. and all other factors were held constant, net sales in such regions would have been $4.7 million higher than reported in the first six months of 2014.
Gross profit increased $29.6 million to $255.7 million for the six months ended June 30, 2014 compared to $226.1 million in the comparable period of 2013. Gross profit as a percentage of net sales (“gross margin”) increased to 43.8% in the first six months of 2014 compared to 42.1% in the first six months of 2013. This increase in gross margin was primarily due to (i) improved manufacturing and distribution efficiencies; (ii) a favorable shift in sales mix to higher margin golf balls and woods products in 2014 compared to 2013, combined with an increase in average selling prices in certain driver products in 2014 compared to 2013; and (iii) charges recognized during the first six months in 2013 related to the Cost Reduction Initiatives. These improvements were partially offset by (i) the net unfavorable impact of changes in foreign currency rates, (ii) an increase in promotional activity on golf club products in the second quarter of 2014 compared to the second quarter of 2013, and (iii) an increase in club component costs due to more expensive materials and technology incorporated into certain putters and woods products launched in the current year.
Selling expenses increased by $7.9 million to $137.9 million (23.6% of net sales) during the six months ended June 30, 2014 compared to $130.0 million (24.2% of net sales) in the comparable period of 2013. This increase was primarily due to a $6.7 million increase in marketing expenses and a $0.9 million increase in stock compensation expense due to a 26% increase in the Company's stock price period over period.
General and administrative expenses increased by $0.7 million to $30.5 million (5.2% of net sales) during the six months ended June 30, 2014 compared to $29.8 million (5.5% of net sales) in the comparable period of 2013. This increase was primarily due to increases of $1.4 million in bad debt expense, and $0.9 million in employee costs. These increases were partially offset by a $1.3 million decrease in legal expenses.
Research and development expenses increased slightly to $14.8 million (2.5% of net sales) during the six months ended June 30, 2014 compared to $14.7 million (2.7% of net sales) in the comparable period of 2013.
Interest expense increased by $0.6 million to $5.6 million during the six months ended June 30, 2014 compared to $5.0 million in the comparable period of 2013 as a result of higher average outstanding borrowings period over period.
Other income (expense), net decreased to other expense of 5.2 million during the six months ended June 30, 2014 compared to other income of $8.7 million in the comparable period of 2013. This decrease was primarily due to a $13.7 million increase in net foreign currency losses in the first six months of 2014 compared to the same period in 2013.
The Company’s provision for income taxes decreased to $3.3 million for the six months ended June 30, 2014, compared to $3.9 million in the comparable period of 2013. Due to the effects of the Company’s valuation allowance against its U.S. deferred tax assets, the Company’s effective tax rate for 2014 is not comparable to the effective tax rate for 2013 as the Company’s provision for income taxes is not directly correlated to pretax income.
Net income for the six months ended June 30, 2014 improved by $7.0 million to $58.7 million compared to $51.7 million in the comparable period of 2013. Diluted earnings per share increased to $0.66 in the first six months of 2014 compared to $0.59 in the comparable period of 2013.


32


Golf Clubs and Golf Balls Segments Results for the Six Months Ended June 30, 2014 and 2013
Golf Clubs Segment
Net sales information by product category is summarized as follows (dollars in millions):
 
Six Months Ended 
 June 30,
 
Growth
 
2014
 
2013(1)
 
Dollars
 
Percent
Net sales:
 
 
 
 
 
 
 
Woods
$
182.2

 
$
168.1

 
$
14.1

 
8
%
Irons
125.8

 
110.5

 
15.3

 
14
%
Putters
58.6

 
53.8

 
4.8

 
9
%
Accessories and other
125.8

 
119.8

 
6.0

 
5
%
 
$
492.4

 
$
452.2

 
$
40.2

 
9
%