Gilford Securities Golf Research

2011 PGA Merchandise Show Report Part 1: State of the Industry

January 26-29, 2011

Orange County Convention Center

Golf is in Peril; What’s the Alternative?

We attended the 2011 PGA Merchandise Show in Orlando FL. Part one of the report deals with the state of the golf industry, and the most topical discussion in relation to the state of the golf industry. Part Two will center around our annual equipment review and will be released a short time later.

Golf is in Peril

The facts are undeniable. The National Golf Foundation recently released the damning statistic that currently for every person that decides to become a new golfer, two people decide to stop playing golf. We know of no business that can suffer that level of attrition for long before the golf industry reenacts Larry the Liquidator’s buggy whip syndrome from the movie ‘Other People’s Money’.

Every aspect of the Golf Industry has a stake in some form of solution: facilities owners, equipment companies, apparel companies, broadcast and print media, and especially golfers themselves.

According to the ‘no longer unauthorized State of the Industry presentation’ from Pellucid Corp and Edgehill Consulting, average golf facility capacity utilization is down near 52%-53%. This means that 48% of the time that a course can be played, it’s not being played. That’s crazy. According to the National Golf Foundation a total of 46 courses were opened in the U.S. last year and 107 were closed, for a net closure of 61 golf courses. Facility owners are slashing costs to keep the doors open, delaying capital expenditures and hanging on in the hopes that economic relief is on the way. According to the Sports & Leisure Research Group, 1/3 of all private courses are now engaged in some form discount golf through the use of aggressive discounting of membership fees in order to survive.

Equipment companies are muddling through a value-based low price environment, also hanging their hats on the hope that the economy will permit their customers to eventually be charged more. They design innovations against the USGA’s performance barriers; barriers that are intended to rein in the PGA Tour professional, but barriers that snare every other golfer in the same net. Grandmothers and 14 year old kids are forced to suffer playing with equipment that for all intents and purposes has the same technical specifications as what is played on the Tour. That’s crazy. One by one, equipment companies are failing at the margin, but sooner or later this trend is going to reach out and crush one of the big guys.

Apparel companies fare somewhat better because millions of non-golfers still like to wear golf shirts. But when you visit the apparel side of the PGA Show, you see dozens and dozens of companies scraping along and trying to grab their share of a green grass market that gets smaller every day. That’s crazy. Major companies that are as substantial as Nike now identify themselves as apparel and footwear companies first, and will attempt to rout the smaller guys in the apparel business out of existence. This strategy is described as returning to core values, but the reality is you have to go where the dollars are going to be spent. Nike is having their Willie Sutton moment in the post-Tiger era, and ultimately allowing Mr. Woods performance speak for itself.

Print media is getting routed not only by the reduction in the number of golfers. Print also has to figure out how to combat the Internet. A prominent magazine actually reached out to their rater group to ask for advertising referrals. That’s crazy. Another recently displaced writer described the upcoming issue of his former mag as “the next pamphlet”. One magazine group spent the entire PGA Show rolling out their Internet/Social Media/Interactive customer strategy. We think this makes sense, but we can help but wonder how long the print versions of these magazines will last. The Internet will give you the entire Tour story on Sunday night. Waiting for the following Friday to read about it in a magazine seems a little out of date for advertising model.

Broadcast media didn’t exactly knock them dead with the lackluster performance of Tiger in 2010. We can only wonder what ad rates for 2011 and beyond must look like. The Bob Hope Classic, a fixture on tour for decades, does not have a title sponsor. That’s crazy. We don’t even know where to go to watch the LPGA Tour now. The LPGA is cancelling tournaments in Mexico because of rebel activity. It sounds like a scene out of Star Wars.

And then there are the golfers. Golfers with or without handicaps play a game that is too hard using a rule book that is a quarter inch thick but requires another book the size of a dictionary to explain. They suffer through rounds that last 5+ hours on courses that are half empty. That is crazy. They are asked to buy new equipment that promises every year to hit the ball farther, even though the equipment conforms to regulations that demand that it actually doesn’t hit the ball any farther.  And yet the average golfer doesn’t demand anything in the way of relief from these regulations that, in reality, have nothing to do with the average golfer. Instead, the average golfer just gets frustrated and quits the game in record numbers.

This is not a pretty picture.

A fair question is how much of what we are seeing is directly related to the recent recession. But we have been arguing about the lack of growth in the game for a decade. These issues were not created by the recession; they were merely accelerated by the recession. But that might be enough to get the industry serious about taking more drastic measures. The First Tee and Get Golf Ready are industry-bred attempts to grow the game, but they only work by degrees. Get Golf Ready is two years old and already undergoing a reformation of its strategic implementation. In the meantime the entire Generation X and Generation Y subset has passed golf by for X-treme sports and X-Box. Drastic times call for drastic measures.

Golf is in Peril: What’s the Alternative?

We have discussed the intransigence of the USGA and the need for bifurcation of the rules in the past. Here is an excerpt from our 2003 PGA Merchandise Show report:

“The primary issue that pulls it all together, in our opinion, is the fact that the stewards of the game, the sanctioning bodies, believe that protecting the traditions of the game and the integrity of the game are almost incompatible with enhancing the financial health of the game. And out of this parochial attitude rise all the other problems that plague the game and the business of golf. Our view is that the sanctioning bodies have taken an approach to protecting the traditions and history of the game that have actually led to retarding the growth of the game. And for that we are sad.”

It just goes to show that issues that were so identifiable 8 years ago have gone completely unaddressed. Don’t misunderstand where we stand on the issues of rules, technological barriers, and the USGA as it relates to the scratch amateur and professional game. We watched touring professionals in San Diego hitting tee shots 350 yards on the 18^th hole at Torrey Pines at sea level! The USGA absolutely has to protect scratch tournament golf from obsoleting the entire golf playground. We have no problem with that. We support that. We applaud that.

Where we take issue is for the rest of the golfing universe, especially those that play handicap golf, or golf for purely recreational reasons. When Callaway Golf tried to market the ERC II driver in the early 2000’s, the USGA made a totally overt attempt to snuff it out of existence. They reached out with letters to clubs stating that if a player used the club that they no longer had a valid handicap. The USGA basically stood on a bully pulpit and decided that they could put limits not just on what tournament golfers could use, but what everyone could use. The golf club equipment industry and by proxy all golf facility owners have been damaged goods ever since.

And for what purpose? If you are playing golf recreationally, you should care less what the USGA says, and you probably do. But because no equipment company wants to get called out by the USGA again, the equipment companies will not make equipment that could allow you to play better and have more fun.

If you have a handicap, and play at your club or with your friends using your handicap, it really shouldn’t matter what you use. Why should anyone care if you play with a Fred Flintstone driver and a super-ball. After 10 rounds your handicap will have adjusted to your current level of play. So what really is the difference? Isn’t it fair to suggest that if equipment existed that allowed more people to get greater enjoyment out of the golf course, that more people would eventually play the game? Intuitively, it seems so. And if more people played the game, they would buy more equipment, and more apparel to wear while they played. And they would become more engaged with the game, and thus likely watch more golf and read more stories about golf.

The golf industry has allowed technology and innovation that could attract millions to the game to become trapped behind a dam. This dam is specifically designed to hinder the touring professional, but it has trapped everyone else in the bargain. Let an alternative form of golf, one that has a broader set of playing guidelines designed to allow technology and innovation flow through, and a game can emerge that is more fun, more inclusive, played faster, and is far less restrictive in terms of the social graces necessary to compete.

It is for these reasons that while at the PGA Merchandise Show we hosted a meeting of the Alternative Golf Association. The Alternative Golf Association (AGA) wants to work through those barriers and open up the game to a much broader constituency. It is led by Scott McNealy, founder and former CEO of Sun Microsystems. The organization wants to drive technology that goes beyond existing regulations and offers an open source environment for technology creation that will allow golf to be enjoyed by a far wider audience. The AGA wants to turn the game around, in essence offering new players a chance to flog, instead of golf. Hence the key website is www.flogton.com . Flogton is symbolically ‘not golf’ spelled backwards.

At issue here is not the things that make golf great. Flogging is not so different from golf as those might imagine. Great golf courses are just wonderful places to be. Floggers use the same courses that golfers do. In fact, floggers and golfers can play in the same group. And in order to be successful, floggers will still have to execute to components of a fundamental golf swing. But equipment can be created that lets golfers hit the ball farther, and straighter and with less spin off the tee and with more spin on the green. Conventions can be adopted that allows recreational floggers to play significantly faster, such as larger hole complexes that merely need to be hit, rather than a tiny hole that must be entered.

But most importantly, the AGA wants the flogging game to be adapted by those that adopt it. The AGA wants not only an open source for technology, but an open source website and social network that create the playing guidelines and conventions of the game as it evolves. This is what the gamer community does now, and it is as alive and interactive as any social network on the planet.

Certain conventions of golf will get obliterated by those that flog. Telling a 14 year boy that he can’t wear jeans and he can’t take his cell phone on the course is not an invitation to having fun playing golf. The 14 year old boy perceives it as punishment! Society has permanently evolved, and the social requirements of the golf course have to evolve with it.

These are just some of the concepts that Scott McNealy outlined to a group of about 65 CEO’s, equipment designers, interested parties and media. The response was electric. It was if someone threw a switch and said it’s time to challenge the conventional. It’s finally ok to step over the line. Silicon Valley is coming to shake up the golf business.

Since the meeting, equipment companies have reached out to ask if they can become designers of alternative equipment. Golf course owners are reaching our asking how they can get their course to be a part of a Flogton pilot program. At this rate, someday Levi’s may have a booth at the PGA Merchandise Show.

Certainly there are challenges. The AGA needs courses to join the AGA in order to develop a broad–based coalition. The AGA needs equipment manufacturers to develop AGA-certified equipment so it can be clearly identified against USGA-conforming equipment. It needs to cut loose technology from the bounds of servitude, and reopen the door to performance-based creativity. It also needs a long-term feeder program for players, something on the order of SNAG (SNAG stands for Starting New At Golf; www.snaggolf.com ). But most importantly, it needs a strategy to get the message to the right ears that ultimately results in new people trying an expanded version of golf. That is always has been the challenge, and will remain the challenge.

In our view, the AGA needs to go in two very specific directions. First of all, while not ignoring any course nationally, the AGA needs to make an effort to dominate a specific region. Our suggestion is Myrtle Beach. Why Myrtle Beach? Simple. Myrtle has about 120 golf courses, almost all resort-type courses. There is substantial under-utilized capacity due to the high concentration of courses in such a small area. Myrtle Beach also has an active tourism/travel bureau that has driving traffic to these 120 golf courses as one of its most important missions. The AGA can provide a new tool in the tourism/travel bureau arsenal to drive family traffic by offering a more player-friendly form of golf, which would be flogging. The AGA could potentially begin with 20-25 sanctioned AGA courses which could stock some AGA-certified rental equipment, and allow resort-type family-oriented new players to become familiar with the game. And then, and this is the most important point, they can take the concept home with them.

The broader interpretation of the game also will need the right spokespeople. It needs people that inspire Gen-X and Gen-Y. People like Shaun White, George Lopez, and Justin Timberlake. These are the names that capture the attention on non-golfers that could potentially be attracted to the game.

And finally, the AGA needs to become a social network in its own right, with communication among players with interactive communities that evolve and adapt the playing guidelines that the actual players find to be most fun and effective. This is how the alternative to traditional golf can become viral. Dot-com and Dot-org presume some ownership of the game. The USGA presumes to own the rights to legislate the game. That’s crazy! The AGA does not propose ownership of the game. It’s time for the ownership of the game to be taken back by the golfers. In reality, it’s time for ownership of the game to be turned over to floggers.

ANALYST CERTIFICATION

I, Casey Alexander, certify that all the views expressed in this research report accurately reflect my personal views of the subject company (ies).  I also certify that I have not and will not receive compensation with respect to the issuance of this report.

REQUIRED DISCLOSURES

In the normal course of business, Gilford Securities seeks to perform investment banking and other services for various companies and to receive compensation in connection with such services.  As such, Gilford Securities intends to seek compensation for investment banking services from the subject companies in the next 3 months.

Callaway Golf is rated a Buy.  No other company mentioned here is currently rated by Gilford Securities, Inc.

ANALYST STOCK RATINGS

Buy The stock should outperform its industry or peer group by 20% or greater within a 12-18 month time frame.

Sell The stock is expected to under-perform its industry or peer group by 20% or greater within a 12-18 month time frame, or where fundamentals of a company have deteriorated significantly and the stock is expected to materially depreciate.

Hold The stock does not have enough upside or downside potential to rate a Buy or Sell. The stock is either fairly valued or has too much uncertainty to have a Buy or Sell rating.