Updated from 4:58 p.m. EST

Can

Callaway Golf

(ELY) - Get Report

escape the sand trap and avoid the water hazards as the economy recovers?

Thursday's

Face-Off with

Glenn Curtis over this high-end golf club and ball manufacturer prompted me to take another look at the company. Sure, I still like those old Steelhead irons, but more sand and water seem to be in the way of Callaway's recovery.

Blind Shots

The slowing economy has taken a toll on the golf business, including Callaway. In the first nine months of 2001, Callaway's net income declined 12%, despite a 2% rise in sales. That slip can be largely attributed to the company's energy costs (more on that later), but there's more to the story, says Callaway's CFO Brad Holiday.

"Following the events of Sept. 11, we postponed our new product introductions ... originally scheduled for September," he said in a statement announcing third-quarter earnings. "We are re-evaluating our 2002 expectations in light of market conditions and expect to offer guidance after we collect feedback from our planned product introductions."

According to CEO Ron Drapeau, "the most dramatic group of product introductions in the history of our company" was announced Nov. 15. Nearly two months later, however, Callaway has yet to update its guidance, and that concerns some investors.

"What happened to the earnings guidance Callaway was going to issue in mid-fourth quarter for the fourth quarter and 2002?" asks one analyst at a buy-side firm that has periodically been short Callaway shares. "We've seen nothing yet."

Callaway spokesperson Larry Dorman said the company will address these issues soon and agreed to refer questions about specific financial issues and the status of the company's five-year

electricity supply contract with

Enron

( ENE) to both Drapeau and Holiday. However, he did indicate that Regulation FD might prohibit them from providing answers to

TSC

before the company's year-end earnings announcement scheduled for later this month.

One reason for Callaway's lack of new guidance may be growing pressures on sales and profits. The analyst notes that Callaway's inventories continue to grow. From Dec. 31, 2000, to Sept. 30, 2001, inventories rose by 8.4%. "If you look at the third-quarter report, the company still has massive old product inventory it is trying to work through," the analyst says.

In another potential sign of weakness, accounts receivables soared, jumping nearly 65% in the first nine months of 2001.

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Finally, the analyst suggests that earnings could have been even worse. "Callaway didn't accrue for warranty reserve at all in the first three quarters of 2001," he explains. "That is a nice benefit to earnings even though the company has indicated no change in warranty experiences, only changes in accounting practices."

The company's accrued warranty reserve actually declined by 8% in the first nine months of 2001. In response, the company's third-quarter 10-Q notes say, "The margin was also favorably affected by a reduction in the Company's warranty expense as a percent of net sales for the nine-month period ended Sept. 30, 2001, as compared to the same period in 2000."

Sand Saves

Though 2001 is history, the past may be prologue for Callaway. November's new-product announcement indicates that Callaway is clearly banking on new demand from the recreational golfer.

"We fully expect that a lot of these products will get significant use on the world's professional tours. But our focus is squarely upon making clubs and balls that offer more forgiveness, the potential for more distance and the opportunity to have a lot of fun while playing golf," said Richard C. Helmstetter, Callaway's chief of new products, in announcing the new offerings.

Callaway's new products received mixed reviews from the pros. "We have interviewed several tour players on the new C4 drivers and hex balls," the analyst says. "The driver will be a nonevent on tour as it doesn't have good response and feel. The hex balls are probably going to do a little better than expected as the hexagonal and non-seam design is great for further lowering air resistance."

He notes that neither is a new innovation in golf: Yonex had a graphite head driver in the mid-'90s that went nowhere, and

Uniroyal

introduced a hexagonal-pattern golf ball in the mid-'70s.

Though it's too early to tell how excited recreational golfers will get about Callaway's new high-end offerings, the marketing game is becoming more expensive. Even before the new-product announcements, Callaway was experiencing an increase in selling costs "due primarily to increased advertising and promotional expenses related to the Company's new product launches, the rollout of the new fitting cart system and store-in-store project and other demand-creation initiatives," according to Callaway's third-quarter 10-Q.

With new unknown products to sell, those costs won't decrease anytime soon.

Power Drivers

But Callaway does seem to have made strides in the golf ball business. Sales for the first nine months of last year were up more than 61% from a base of just $27 million in 2000. Yet the ball business had yet to turn a profit in 2001, according to the company's third-quarter filing.

"The golf ball business is the most competitive aspect of the golf business," says the analyst. "You have Titleist,

Nike

(NKE) - Get Report

, Precept and everyone else with new balls, which won't help profits or margins."

Finally, there's that electricity supply contract, signed with Enron last year, which provided power for Callaway's manufacturing needs and more at a cost of about $110 per megawatt hour. Today, power in California sells for about $30 per megawatt hour. As a result, Callaway took nearly $20 million in noncash charges in the first nine months of 2001, a number that could grow larger over time.

Back then, Callaway claimed that the contract would not only lower its operating costs but also present profit potential because it could resell excess power at a profit. However, that contract now appears to be nothing more than a dim bulb hanging over Callaway's earnings. The only saving grace could be early termination of the contract as a result of Enron's bankruptcy.

For Callaway, the power business was clearly a subpar investment.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

Chris Edmonds.