CALLAWAY GOLF CO /CA - 10-Q Quarterly Report

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 þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes þ No o

The number of shares outstanding of the Registrant’s Common Stock, $.01 par value, as of October 29, 2004 was 76,284,277.

Important Notice to Investors: Statements made in this report that relate to future plans, events, liquidity, financial results or performance including statements relating to future cash flows, as well as estimated charges to earnings, projected amortization expenses and contractual obligations, are forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. These statements are based upon current information and expectations. Actual results may differ materially from those anticipated as a result of certain risks and uncertainties. For details concerning these and other risks and uncertainties, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Certain Factors Affecting Callaway Golf Company” contained in this report, as well as the Company’s other reports on Forms 10-K, 10-Q and 8-K subsequently filed with the Securities and Exchange Commission from time to time. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to update forward-looking statements to reflect 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.

Callaway Golf Company Trademarks: The following marks and phrases, among others, are trademarks of Callaway Golf Company: A Passion For Excellence — Apex — Apex Edge — Apex Plus — Ben Hogan — BH design — Big Ben — Big Bertha — C design — CB1 — CTU 30 — Callaway — Callaway Connect — Callaway Golf — Chevron Device — Dawn Patrol — Daytripper — Demonstrably Superior and Pleasingly Different — Deuce — DOT — DFX — Divine Nine — Dual Force — Dual Zone — Eagle — Ely Would — ERC — Flying Lady — FTX — Fusion — Game Enjoyment System — Gems — GES — Ginty — Great Big Bertha — Hawk Eye — Heavenwood — Hogan — HX — Legacy — Legend — Magna — Molitor — Number One Putter In Golf — Odyssey — Pure Distance — RCH — Rossie — Rule 35 — S2H2 — Slickote — S.O.A.R. — Speed Slot — Steelhead — Strata — Stronomic — STS — T design — The Hawk — The Longest Balls — The Most Played Name In Golf — Trade In! Trade Up! — Top-Flite — Tour 100 — Tour Blue — Tour Edition — Tour Impact — Tour Straight — Tour Ultimate — TriForce — TriHot — Tru Bore — VFT — War Bird — Warbird — White Hot — White Steel — World’s Friendliest — X-12 — X-14 — X-16 — X-18 — XL — XL 2000 — XL 3000 — X-SPANN — XWT — Z-Balata.

The accompanying unaudited interim financial statements have been prepared by Callaway Golf Company (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States 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, 2003 filed with the Securities and Exchange Commission. These consolidated condensed financial statements, in the opinion of management, include all adjustments (consisting only of normal recurring accruals) 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 accounting principles generally accepted in the United States 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. Certain prior period amounts have been reclassified to conform with the current period presentation.

On May 28, 2004, the Company acquired all of the issued and outstanding shares of stock of FrogTrader, Inc. (“FrogTrader”). The Company’s consolidated statements of operations include the financial results of FrogTrader for the period from the acquisition date of May 28, 2004 through September 30, 2004. FrogTrader has partnered with Callaway Golf and its participating retailers for the past two years to develop the Trade In! Trade Up! program. The Company acquired FrogTrader to better position the Company to stimulate purchases of new clubs by growing the Trade In! Trade Up! program and to enable the Company to better manage the distribution of pre-owned golf clubs and the Callaway Golf brand.

The FrogTrader acquisition was accounted for as a purchase in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations.” Under SFAS No. 141, the aggregate cost of the acquired stock was $15,175,000, which included transactional costs of approximately $215,000, and was paid entirely in cash. The aggregate acquisition costs exceeded the estimated fair value of the net assets acquired. As a result, the Company has recorded goodwill of $8,863,000, none of which is deductible for tax purposes. In accordance with the applicable accounting rules, a full determination of the allocation of the aggregate acquisition costs will be made upon a final assessment of the estimated fair value of the acquired net assets. As of September 30, 2004, we have recorded the fair values of FrogTrader’s internally developed software and certain customer information based on a preliminary assessment from an outside valuation company received during the quarter. It is anticipated that the final assessment will be completed prior to the

end of 2004 and will not differ materially from the preliminary allocation. The preliminary allocation as of September 30, 2004 is as follows (in thousands):

On September 15, 2003, the Company acquired through a court-approved sale substantially all of the golf-related assets of TFGC Estate Inc. (f/k/a The Top-Flite Golf Company, f/k/a Spalding Sports Worldwide, Inc.) and thereafter completed the valuation and settlement of certain additional assets related to the international operations of TFGC Estate Inc. (the “Top-Flite Acquisition”). The settlement of the international assets was effective October 1, 2003. Assets located in the United States were acquired by the Company’s newly-formed, wholly-owned subsidiary, The Top-Flite Golf Company. Foreign assets were acquired by the Company’s existing wholly-owned subsidiaries in the relevant countries.

The acquisition of the Top-Flite assets provided a unique opportunity to significantly increase the size and profitability of the Company’s golf ball business and the Company was able to purchase the acquired assets at less than their estimated fair value. The Company paid the cash purchase price for the Top-Flite Acquisition from cash on hand. The Company intends to continue the U.S. and foreign operations of the acquired golf assets, including the use of acquired assets in the manufacturing of golf balls and golf clubs and the commercialization of the Top-Flite and Ben Hogan brands, patents and trademarks.

The Company’s consolidated statements of operations include Top-Flite’s results of operations for the three and nine months ended September 30, 2004. For the three and nine month periods ended September 30, 2003, the Company’s consolidated statements of operations included only 15 days of Top-Flite’s results of operations in the U.S.

The Top-Flite Acquisition was accounted for as a purchase in accordance with SFAS No. 141. Under SFAS No. 141, the estimated aggregate cost of the acquired assets is $182,960,000, which includes cash paid of $154,145,000, transaction costs of approximately $6,331,000, and assumed liabilities of approximately $22,484,000. The estimated fair value of the net assets exceeded the estimated aggregate acquisition costs. As

a result, the Company was required to reduce the carrying value of the acquired long-term assets on a pro rata basis. The allocation of the aggregate acquisition costs as of September 30, 2004 is as follows (in thousands):

During the three and nine month periods ended September 30, 2004, the Company recorded pre-tax charges of $7,468,000 and $23,264,000, respectively, associated with the integration of the Callaway Golf and Top-Flite operations. The integration charges included $2,860,000 and $8,558,000 of accelerated depreciation for the three and nine month periods ended September 30, 2004, respectively, associated with golf ball manufacturing equipment that will no longer be in use upon completion of the Company’s integration efforts to consolidate the Callaway Golf and Top-Flite golf ball manufacturing operations. The integration charges also include employee severance and relocation costs, professional fees and building consolidation expenses.

The Company accounts for its stock-based employee compensation plans using the recognition and measurement principles (intrinsic value method) of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company recorded compensation expense of $99,000 during the three and nine months ended September 30, 2004 as a result of restricted stock awards granted in connection with the FrogTrader acquisition. For the three and nine months ended September 30, 2003, the Company recorded compensation expense of $0 and $15,000 as a result of the restricted stock awards that were granted in 1998 and which vested in January 2003. All other employee stock-based awards were stock options which were granted with an exercise price equal to the market value of the underlying common stock on the date of grant and no compensation cost is reflected in net income from operations for those awards. Pro forma disclosures of net income (loss) and earnings (loss) per share, as if the fair value-based recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” had

been applied in measuring stock-based employee compensation expense, are as follows (in thousands, except per share data):

The pro forma amounts reflected above may not be representative of future disclosures since the estimated fair value of stock options is amortized to expense as the options vest and additional options may be granted in future years. The fair value of employee stock options was estimated at the date of grant using the Black-Scholes option-pricing model with the following assumptions:

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in subjective input assumptions can materially affect the fair value estimates, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of grants under the Company’s employee stock-based compensation plans.

The Company determines the appropriate classification of its investments at the time of purchase and reevaluates such determination at each balance sheet date. Trading securities are carried at quoted fair value, with unrealized gains and losses included in earnings. Available-for-sale securities are carried at quoted fair value, with unrealized gains and losses reported in shareholders’ equity as a component of accumulated other comprehensive income. The Company held no marketable securities at September 30, 2004 or 2003. Investments in limited partnerships that do not have readily determinable fair values are stated at cost and are

reported in other assets. Realized gains and losses are determined using the specific identification method and are included in other income (expense), net.

Effective January 1, 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” As a result of adopting SFAS No. 142, the Company’s goodwill and certain intangible assets are no longer amortized, but are subject to an annual impairment test. The following sets forth the intangible assets by major asset class (in thousands):


⁽¹⁾	Acquired through acquisition transactions.

⁽²⁾	Changes in gross value during the nine months ended September 30, 2004 were affected by the final assessment of the estimated fair value of the acquired Top-Flite assets. See Note 2.

⁽³⁾	The gross balance of patents at September 30, 2004 and December 31, 2003 acquired during business acquisition transactions was $19,853,000 and $19,114,000, respectively. The accumulated amortization balance of acquired patents at September 30, 2004 and December 31, 2003, was $4,104,000 and $3,131,000, respectively.

⁽⁴⁾	The gross balance of other intangibles at September 30, 2004 and December 31, 2003 acquired during business acquisition transactions was $2,987,000 and $4,293,000, respectively. The accumulated amortization balance of other acquired intangibles at September 30, 2004 and December 31, 2003 was $1,103,000 and $364,000, respectively.

Intangible assets with definite lives are amortized using the straight-line method over periods ranging from 1 to 16 years. During the three months ended September 30, 2004 and 2003, aggregate amortization expense for such assets was approximately $705,000 and $352,000, respectively. During the nine months ended September 30, 2004 and 2003, aggregate amortization expense was approximately $2,470,000 and $1,055,000, respectively. Amortization expense related to intangible assets at September 30, 2004 in each of the next five fiscal years and beyond is estimated to be incurred as follows (in thousands):

Changes in goodwill during the nine months ended September 30, 2004 were primarily due to the acquisition of FrogTrader (see Note 2 for further details) which resulted in approximately $8,863,000 of goodwill. The remaining change of $89,000 related to foreign currency exchange rate fluctuations.

At September 30, 2004, the Company had a $100,000,000 revolving line of credit with Bank of America, N.A. and certain other lenders (the “2003 Line of Credit”). At September 30, 2004, there were no borrowings outstanding under the 2003 Line of Credit and the Company was in compliance with all of the covenants and other terms thereof. The 2003 Line of Credit was scheduled to expire by its terms on November 9, 2004.

Effective November 5, 2004, the Company amended and restated the 2003 Line of Credit to provide for a new five year revolving line of credit from Bank of America, N.A. and certain other lenders, providing for revolving loans of up to $300,000,000, of which $250,000,000 consisted of commitments available at the closing and the balance of which are available to the Company upon the satisfaction of certain conditions. Actual borrowing availability under the new credit facility is limited effectively by the financial covenants set forth in the new credit facility. As of the date of this report, the maximum amount that could be borrowed under the new credit facility was approximately $134,000,000. As of the date of this report, no borrowings were outstanding under the new credit facility and the Company was in compliance with the covenants and other terms thereof.

In connection with the new credit facility, the Company is required to pay certain fees, including an unused commitment fee of between 17.5 to 35.0 basis points per annum of the unused commitment amount, with the exact amount determined based upon the Company’s consolidated leverage ratio and trailing four quarters EBITDA (each as defined in the new credit facility). Outstanding borrowings under the new credit facility accrue interest at the Company’s election, based upon the Company’s consolidated leverage ratio and trailing four quarters EBITDA, of (i) the higher of (a) the Federal Funds Rate plus 50.0 basis points or (b) Bank of America’s prime rate, and in either case plus a margin of 00.0 to 75.0 basis points or (ii) the Eurodollar Rate (as defined in the new credit facility) plus a margin of 75.0 to 200.0 basis points. The Company has agreed that repayment of amounts under the new credit facility will be guaranteed by certain of the Company’s domestic subsidiaries and will be secured by substantially all of the assets of the Company and such guarantor subsidiaries. The collateral (other than 65% of the stock of the Company’s foreign subsidiaries) will be released upon the satisfaction of certain financial conditions.

The new credit facility agreement requires the Company to maintain certain financial covenants, including a maximum leverage ratio, a minimum asset coverage ratio, a maximum capitalization ratio, a minimum interest coverage ratio and a minimum consolidated EBITDA. The new credit facility agreement also includes certain other restrictions, including restrictions limiting additional indebtedness, dividends, stock repurchases, transactions with affiliates, capital expenditures, asset sales, acquisitions, mergers, liens and encumbrances and other restrictions that are customary in credit facility agreements of this type. The new credit facility also contains other customary provisions, including affirmative covenants, representations and warranties and events of default.

The above summary of the provisions of the new credit facility is qualified in its entirety by the terms of the new credit facility, as set forth in Exhibit 10.48 to this Form 10-Q.

In connection with the Top-Flite Acquisition, the Company assumed capital lease obligations which had an aggregate outstanding balance of $81,000 at September 30, 2004, related primarily to computer and telecommunication systems. The lease agreements expire in 2006.

The Company has a stated two-year warranty policy for its golf clubs, although the Company’s historical practice has been to honor warranty claims well after the two-year stated warranty period. The Company’s policy is to accrue the estimated cost of warranty coverage 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 warranty expense (in thousands):

A reconciliation of the weighted average shares used in the basic and diluted earnings (loss) per common share computations for the three and nine months ended September 30, 2004 and 2003 is presented below (in thousands):

Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Options with an exercise price in excess

of the average market value of the Company’s common stock during the period have been excluded from the calculation as their effect would be antidilutive. Additionally, potentially dilutive securities are excluded from the computation of earnings per share in periods in which a net loss is reported as their effect would be antidilutive. Thus, weighted–average shares outstanding — Diluted is the same as weighted-average shares outstanding — Basic in periods when a net loss is reported. For the three months ended September 30, 2004 and 2003, options outstanding totaling 13,049,000 and 9,846,000 shares, respectively, were excluded from the calculations, as their effect would have been antidilutive. For the nine months ended September 30, 2004 and 2003, options outstanding totaling 9,634,000 and 11,160,000 shares, respectively, were excluded from the calculations, as their effect would have been antidilutive.

In conjunction with the Company’s program of enforcing its proprietary rights, the Company has initiated or may initiate actions against alleged infringers under the intellectual property laws of various countries, including, for example, the U.S. Lanham Act, the U.S. Patent Act, and other pertinent laws. Defendants in these actions may, among other things, contest the validity and/or the enforceability of some of the Company’s patents and/or trademarks. Others may assert counterclaims against the Company. Historically, these matters individually and in the aggregate have not had a material adverse effect upon the financial position or results of operations of the Company. It is possible, however, that in the future one or more defenses or claims asserted by defendants in one or more of those actions may succeed, resulting in the loss of all or part of the rights under one or more patents, loss of a trademark, a monetary award against the Company or some other material loss to the Company. One or more of these results 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 from time to time receives information claiming that products sold by the Company infringe or may infringe patent or other intellectual property rights of third parties. It is possible that one or more 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.

In the fall of 1999 the Company adopted a unilateral sales policy called the “New Product Introduction Policy” (“NPIP”). The NPIP sets forth the terms on which Callaway Golf chooses to do business with its customers with respect to the introduction of new products. The NPIP has been the subject of several legal challenges. Currently pending cases, described below, include Lundsford v. Callaway Golf, Case No. 2001-24-IV, pending in Tennessee state court (“Lundsford I”); Foulston v. Callaway Golf, Case No. 02C3607, pending in Kansas state court; Murray v. Callaway Golf Sales Company, Case No. 3:04CV274-H, pending in the United States Court for the Western District of North Carolina; and Lundsford v. Callaway Golf, Civil Action No. 3:04-cv-442 (“Lundsford II”).

Lundsford I was filed on April 6, 2001, and seeks to assert a punitive class action by plaintiff on behalf of himself and on behalf of consumers in Tennessee and Kansas who purchased select Callaway Golf products covered by the NPIP on or after March 30, 2000. Plaintiff asserts violations of Tennessee and Kansas antitrust and consumer protection laws and is seeking damages, restitution and punitive damages. The court has not made any determination that the case may proceed in the form of a class action.

In Foulston, filed on November 4, 2002, plaintiff seeks to assert an alleged class action on behalf of Kansas consumers who purchased Callaway Golf products covered by the NPIP and seeks damages and restitution for the alleged class under Kansas law. The trial court in Foulston stayed the case in light of

Lundsford I. The Foulston court has not made any determination that the case may proceed in the form of a class action.

The complaint in Murray was filed on May 14, 2004, alleging that a retail golf business was damaged by the alleged refusal of Callaway Golf Sales Company to sell certain products after the store violated the NPIP, and by the failure to permit plaintiff to sell Callaway Golf products on the internet. The proprietor seeks compensatory and punitive damages associated with the failure of his retail operation. Callaway Golf removed the case to the United States District Court for the Western District of North Carolina, and has answered the complaint denying liability.

Lundsford II was filed on September 28, 2004 in the United States District Court for the Eastern District of Tennessee. The complaint in Lundsford II asserts that the NPIP constitutes an unlawful resale price agreement and an attempt to monopolize golf club sales prohibited by federal antitrust law. The complaint also alleges a violation of the state antitrust laws of Tennessee, Kansas, South Carolina and Oklahoma. Lundsford II seeks to assert a nationwide class action consisting of all persons who purchased Callaway Golf clubs subject to the NPIP on or after March 30, 2000. Plaintiff seeks treble damages under the federal antitrust laws, compensatory damages under state law, and an injunction. The Lundsford II court has not made a determination that the case may proceed in the form of a class action.

On October 3, 2001, the Company filed suit in the United States District Court for the District of Delaware, Civil Action No. 01-669, against Dunlop Slazenger Group Americas, Inc., d/b/a Maxfli (“Maxfli”), for infringement of a golf ball aerodynamics patent owned by the Company, U.S. Patent No. 6,213,898 (the “Aerodynamics Patent”). The Company later amended its complaint to add a claim that Maxfli engaged in false advertising by claiming that its A10 golf balls were the “longest ball on tour.” Maxfli answered the complaint denying patent infringement and false advertising, and also filed a counterclaim asserting that former Maxfli employees hired by the Company had disclosed confidential Maxfli trade secrets to the Company, and that the Company had used that information to enter the golf ball business. In the counterclaim, Maxfli sought compensatory damages of $30,000,000; punitive damages equal to two times the compensatory damages; prejudgment interest; attorneys’ fees; a declaratory judgment; and injunctive relief. On November 12, 2003, pursuant to an agreement between the Company and Maxfli, the court dismissed the Company’s claim for infringement of the Aerodynamics Patent. On May 13, 2004, the Court granted the Company’s motion for summary judgment, eliminating a portion of Maxfli’s counterclaim and reducing Maxfli’s compensatory damages claim from approximately $30,000,000 to $18,500,000. The case was tried to a jury beginning on August 2, 2004. On August 12, 2004, the jury returned a verdict of $2,200,000 in favor of the Company based upon its finding that Maxfli willfully engaged in false advertising. The jury also rejected Maxfli’s counterclaim that the Company used any Maxfli trade secrets. Maxfli filed post-trial motions seeking to set aside the verdict and/or obtain a new trial. In post-trial motions Callaway Golf is seeking attorneys’ fees and prejudgment interest. It is expected that if Maxfli is unsuccessful, it will appeal the verdict. If Maxfli is successful with its post-trial motions, or an appeal of the verdict, and Maxfli’s counterclaims are ultimately resolved in Maxfli’s favor, such matters could have a significant adverse effect upon the Company’s results of operations, cash flows and financial position.

On December 20, 2002, the Company removed the case to the United States District Court for the Southern District of Florida, Case No. 02-14342. On April 29, 2003, the District Court denied plaintiffs’ motion to remand the case to state court. Plaintiffs are seeking compensatory damages ranging from $11,500,000 for alleged breach of contract to $206,000,000 for alleged unjust enrichment, plus punitive damages. The trial of the action is scheduled to commence in September 2005. An unfavorable resolution of plaintiffs’ claims could have a material adverse effect upon the Company’s results of operations, cash flows and financial position.

The Company and its subsidiaries, incident to their business activities, are parties to a number of legal proceedings, lawsuits and other claims, including the matters specifically noted above. Such matters are subject to many uncertainties and outcomes are not predictable with assurance. Consequently, management is unable to estimate the ultimate aggregate amount of monetary liability, amounts which may be covered by insurance, or the financial impact with respect to these matters. Except as discussed above with regard to the Maxfli litigation, Perfect Putter litigation, or the cases challenging the NPIP, management believes at this time that the final resolution of these matters, individually and in the aggregate, will not have a material adverse effect upon the Company’s consolidated annual results of operations, cash flows or financial position.

In the second quarter of 2001, the Company entered into an agreement with Pilot Power Group, Inc. (“Pilot Power”) as the Company’s energy service provider and in connection therewith entered into a long-term, fixed-priced, fixed-capacity, energy supply contract (the “Enron Contract”) with Enron Energy Services, Inc. (“EESI”), a subsidiary of Enron Corporation, as part of a comprehensive strategy to ensure the uninterrupted supply of energy while capping electricity costs in the volatile California energy market. The Enron Contract provided, subject to the other terms and conditions of the contract, for the Company to purchase nine megawatts of energy per hour from June 1, 2001 through May 31, 2006 (394,416 megawatts over the term of the contract). The total purchase price for such energy over the full contract term would have been approximately $43,484,000.

At the time the Company entered into the Enron Contract, nine megawatts per hour was in excess of the amount the Company expected to be able to use in its operations. The Company agreed to purchase this amount, however, in order to obtain a more favorable price than the Company could have obtained if the Company had purchased a lesser quantity. The Company expected to be able to sell any excess supply through Pilot Power.

On November 29, 2001, the Company notified EESI that, among other things, EESI was in default of the Enron Contract and that based upon such default, and for other reasons, the Company was terminating the Enron Contract effective immediately. At the time of termination, the contract price for the remaining energy to be purchased under the Enron Contract through May 2006 was approximately $39,126,000.

On November 30, 2001, EESI notified the Company that it disagreed that it was in default of the Enron Contract and that it was prepared to deliver energy pursuant to the Enron Contract. On December 2, 2001, EESI, along with Enron Corporation and numerous other related entities, filed for bankruptcy. Since November 30, 2001, the parties have not been operating under the Enron Contract and Pilot Power has been providing energy to the Company from alternate suppliers.

As a result of the Company’s notice of termination to EESI, and certain other automatic termination provisions under the Enron Contract, the Company believes that the Enron Contract has been effectively and appropriately terminated. There can be no assurance that EESI or another party will not assert a future claim against the Company or that a bankruptcy court or arbitrator will not ultimately nullify the Company’s termination of the Enron Contract. No provision has been made for contingencies or obligations, if any, under the Enron Contract beyond November 30, 2001.

The Company is dependent on a limited number of suppliers for its clubheads and shafts, some of which are single-sourced. In addition, some of the Company’s products require specifically developed manufacturing techniques and processes which make it difficult to identify and utilize alternative suppliers quickly. The Company believes that suitable clubheads and shafts could be obtained from other manufacturers in the event its regular suppliers (because of financial difficulties or otherwise) are unable or fail to provide suitable components. However, any significant production delay or disruption caused by the inability of current suppliers to deliver or the transition to other suppliers could have a material adverse impact on the Company’s results of operations. The Company is also single-sourced or dependent on a limited number of suppliers for the materials it uses to make its golf balls. Many of the materials are customized for the Company. Any delay or interruption in such supplies could have a material adverse impact upon the Company’s golf ball business. If the Company did experience any such delays or interruptions, there is no assurance that the Company would be able to find adequate alternative suppliers at a reasonable cost or without significant disruption to its business.

The Company establishes relationships with professional golfers in order to evaluate and promote Callaway Golf, Odyssey, Top-Flite and Ben Hogan branded products. The Company has entered into endorsement arrangements with members of the various professional tours, including the Champions Tour, the PGA Tour, the LPGA Tour, the PGA European Tour, the Japan Golf Tour and the Nationwide Tour. Many of these contracts provide incentives for successful performances using the Company’s products. For example, under these contracts, the Company could be obligated to pay a cash bonus to a professional who wins a particular tournament while playing the Company’s golf clubs or golf balls. It is not possible to predict with any certainty the amount of such performance awards the Company will be required to pay in any given year. Such expenses, however, are an ordinary part of the Company’s business and the Company does not believe that the payment of these performance awards will have a material adverse effect upon the Company.

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 products, (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 claims 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 made contractual commitments to certain employees providing for severance payments upon the occurrence of certain prescribed events. The Company also 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 a guarantee in the form of a standby letter of credit as security for contingent liabilities under certain workers’ compensation insurance policies. 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 will be required under the commitments and guarantees described above. The fair value of indemnities, commitments and guarantees that the Company

issued during the nine months ended September 30, 2004 was not material to the Company’s financial position, results of operations or cash flows.

The Company has entered into employment contracts with each of the Company’s officers. These contracts generally provide for severance benefits, including salary continuation, if employment is terminated 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 interests in the event of an actual or threatened change in control of the Company, the contracts also generally provide for certain protections in the event of such a change in control. These protections include the extension of employment contracts and the payment of certain severance benefits, including salary continuation, upon the termination of employment following a change in control. The Company is also generally obligated to reimburse such officers for the amount of any excise taxes associated with such benefits.

The Company’s operating segments are organized on the basis of products and include Golf Clubs and Golf Balls. The Golf Clubs segment consists primarily of Callaway Golf, Top-Flite and Ben Hogan woods, irons, wedges and putters as well as Odyssey putters and other golf-related accessories. The Golf Balls segment consists primarily of Callaway Golf, Top-Flite and Ben Hogan 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).


⁽¹⁾	The information presented in this table includes the operations of Top-Flite for the three and nine month periods ended September 30, 2004. As the Top-Flite Acquisition did not occur until the third quarter of 2003, the results reported for the three and nine months ended September 30, 2003 are primarily


	representative of the Callaway Golf Company and Odyssey brand operations, but also include 15 days of Top-Flite Golf operating results in the United States.

⁽²⁾	The Company’s 2004 income (loss) before income taxes includes the recognition of integration charges in the amount of approximately $3,310,000 and $10,379,000 for the three and nine months ended September 30, 2004, respectively, related to the integration of the Callaway Golf and Top-Flite golf ball operations.

⁽³⁾	Represents corporate general and administrative expenses and other income (expense) not utilized by management in determining segment profitability. The reconciling items include the recognition of non-allocated integration charges in the amount of approximately $4,158,000 and $12,885,000 for the three and nine months ended September 30, 2004, respectively, related to the integration of the Callaway Golf and Top-Flite operations. The increase in reconciling items for 2004 as compared to 2003 is primarily due to these integration charges and the addition of Top-Flite reconciling items in 2004.

⁽⁴⁾	Additions for the three and nine months ended September 30, 2003 include long-lived assets acquired as part of the Top-Flite golf operations in the United States.

The Company uses derivative financial instruments to manage its exposures to foreign exchange rates. The Company also utilized a derivative commodity instrument to manage its exposure to electricity rates in the volatile California energy market during the period of June 2001 through November 2001. The derivative instruments are accounted for pursuant to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities.” As amended, SFAS No. 133 requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet, measure those instruments at fair value and recognize 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.

The Company enters into foreign exchange contracts to hedge against exposure to changes in foreign currency exchange rates. Such contracts are designated at inception to the related foreign currency exposures being hedged, which include anticipated intercompany sales of inventory denominated in foreign currencies, payments due on intercompany transactions from certain wholly-owned foreign subsidiaries, and anticipated sales by the Company’s wholly-owned European subsidiary for certain Euro-denominated transactions. Hedged transactions are denominated primarily in British Pounds, Euros, Japanese Yen, Korean Won, Canadian Dollars and Australian Dollars. To achieve hedge accounting, contracts must reduce the foreign currency exchange rate risk otherwise inherent in the amount and duration of the hedged exposures and comply with established risk management policies. Pursuant to its foreign exchange hedging policy, the Company may hedge anticipated transactions and the related receivables and payables denominated in foreign currencies using forward foreign currency exchange rate contracts and put or call options. Foreign currency derivatives 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 exchange contracts for speculative purposes. Hedging contracts mature within twelve months from their inception.

At September 30, 2004 and 2003, the notional amounts of the Company’s foreign exchange contracts were approximately $33,530,000 and $87,714,000, respectively. The Company estimates the fair values of derivatives based on quoted market prices or pricing models using current market rates, and records all

derivatives on the balance sheet at fair value. At September 30, 2004, the fair value of foreign currency-related derivatives were recorded as current assets of $187,000 and current liabilities of $671,000.

There were no notional amounts of the Company’s foreign exchange contracts designated as cash flow hedges at September 30, 2004. At September 30, 2003, the notional amounts of the Company’s foreign exchange contracts designated as cash flow hedges were approximately $42,886,000. For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is initially recorded in accumulated other comprehensive income (“OCI”) as a separate component of shareholders’ equity and subsequently reclassified into earnings in the period during which the hedged transaction is recognized in earnings. During the three and nine months ended September 30, 2004 and 2003, the Company recorded the following activity in OCI (in thousands):

During the three and nine months ended September 30, 2004, no gains or losses were reclassified into earnings as a result of the discontinuance of cash flow hedges. As of September 30, 2004, $88,000 of deferred net losses related to derivative instruments designated as cash flow hedges were included in OCI. These derivative instruments hedge transactions that are expected to occur within the next twelve months. As the hedged transactions are completed, the related deferred net gain or loss is reclassified from OCI into earnings. The Company does not expect that such reclassifications will have a material effect on the Company’s earnings, as any gain or loss on the derivative instruments generally would be offset by the opposite effect on the related underlying transactions.

The ineffective portion of the gain or loss for derivative instruments that are designated and qualify as cash flow hedges is immediately reported as a component of other income (expense), net. For foreign currency contracts designated as cash flow hedges, hedge effectiveness is measured using the spot rate. Changes in the spot-forward differential are excluded from the test of hedging effectiveness and are recorded currently in earnings as a component of other income (expense), net. During the three months ended September 30, 2004 no gains or losses were recorded on derivative instruments. During the three months ended September 30, 2003, the Company recorded net gains of $35,000 as a result of changes in the spot-forward differential. During the nine months ended September 30, 2004 and 2003, the Company recorded net losses of $103,000 and $50,000, respectively, as a result of changes in the spot-forward differential. Assessments of hedge effectiveness are performed using the dollar offset method and applying a hedge effectiveness ratio between 80% and 125%. Given that both the hedged item and the hedging instrument are evaluated using the same spot rate, the Company anticipates the hedges to be highly effective. The effectiveness of each derivative is assessed quarterly.

At September 30, 2004 and 2003, the notional amounts of the Company’s foreign exchange contracts used to hedge outstanding balance sheet exposures were approximately $33,530,000 and $44,828,000, respectively. The gains and losses on foreign currency contracts used to hedge balance sheet exposures are recognized as a component of other income (expense), net in the same period as the remeasurement gain and loss of the related foreign currency denominated assets and liabilities and thus offset these gains and losses. During the three months ended September 30, 2004 and 2003, the Company recorded net losses of $915,000

and $716,000, respectively, due to net realized and unrealized gains and losses on contracts used to hedge balance sheet exposures. During the nine months ended September 30, 2004 and 2003, the Company recorded net losses of $282,000 and $5,021,000, respectively, due to net realized and unrealized losses on contracts used to hedge balance sheet exposures.

In the second quarter of 2001, the Company entered into a long-term, fixed-price, fixed-capacity, energy supply contract as part of a comprehensive strategy to ensure the uninterrupted supply of electricity while capping costs in the volatile California electricity market. The contract was originally effective through May 2006. This derivative did not qualify for hedge accounting treatment under SFAS No. 133. Therefore, the Company recognized in earnings the changes in the estimated fair value of the contract based on current market rates as unrealized energy derivative losses. During the fourth quarter of 2001, the Company notified the energy supplier that, among other things, the energy supplier was in default of the energy supply contract and that based upon such default, and for other reasons, the Company was terminating the energy supply contract. As a result, the Company adjusted the estimated fair value of this contract through the date of termination. As the contract is terminated and neither party to the contract is performing pursuant to the terms of the contract, the terminated contract ceased to represent a derivative instrument in accordance with SFAS No. 133. The Company, therefore, no longer records future valuation adjustments for changes in electricity rates. The Company continues to reflect the derivative valuation account on its balance sheet, subject to periodic review, in accordance with SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” Any non-cash unrealized gains to be recognized upon extinguishment of the derivative valuation account would be reported as non-operating income.

As of the date of termination of the energy supply contract, the derivative valuation account reflected $19,922,000 of unrealized losses resulting from changes in the estimated fair value of the contract. The fair value of the contract was estimated at the time of termination based on market prices of electricity for the remaining period covered by the contract. The net differential between the contract price and estimated market prices for future periods was applied to the volume stipulated in the contract and discounted on a present value basis to arrive at the estimated fair value of the contract at the time of termination. The estimate was highly subjective because quoted market rates directly relevant to the Company’s local energy market and for periods extending beyond a 10- to 12-month horizon were not quoted on a traded market. In making the estimate, the Company instead had to rely upon near-term market quotations and other market information to determine an estimate of the fair value of the contract. In management’s opinion, there are no available contract valuation methods that provide a reliable single measure of the fair value of the energy derivative because of the lack of quoted market rates directly relevant to the terms of the contract and because changes in subjective input assumptions can materially affect the fair value estimates. See Note 10 for a discussion of contingencies related to the termination of the Company’s derivative energy supply contract.

Comprehensive income (loss) is defined as all changes in a company’s net assets except changes resulting from transactions with shareholders. It differs from net income in that certain items currently recorded to equity would be a part of comprehensive income (loss). The following table sets forth the computation of comprehensive income (loss) for the periods presented (in thousands):

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” on the inside cover of this report.

The Company’s discussion and analysis of its results of operations, financial condition and liquidity set forth in this Item 2 have been derived from financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). In addition to the GAAP results of operations, the Company has also provided additional information concerning the Company’s results that includes certain financial measures not prepared in accordance with GAAP. The non-GAAP financial measures included in this discussion are pro forma net income and earnings per share amounts that exclude charges associated with the integration of the Top-Flite business. This discussion also includes results of the Callaway Golf brand (including Odyssey) operations and Top-Flite brand (including Ben Hogan) operations on a stand-alone basis and/or excluding such integration charges, although such operations are not reportable business segments. These non-GAAP financial measures should not be considered a substitute for any measure derived in accordance with GAAP. These non-GAAP financial measures may also be inconsistent with the manner in which similar measures are derived or used by other companies. Management believes that the presentation of such non-GAAP financial measures, when considered in conjunction with the most directly comparable GAAP financial measures, provides useful information to investors by permitting additional relevant period-to-period comparisons of the historical operations of the Callaway Golf business excluding the operations of the recently acquired Top-Flite business, as well as information concerning operations excluding the effect of significant special charges such as the 2004 Top-Flite integration charges. The Company has included in this discussion supplemental information which reconciles those non-GAAP financial measures to the most directly comparable financial measures prepared in accordance with GAAP.

The Company’s discussion and analysis of its results of operations, financial condition and liquidity are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments 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. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may materially differ from these estimates under different assumptions or conditions. On an on-going basis, the Company reviews its estimates to ensure that the estimates appropriately reflect changes in its business or as new information becomes available.

Management believes the following critical accounting policies affect its more significant estimates and assumptions used in the preparation of its consolidated financial statements:

Sales are recognized when both title and risk of loss transfer to the customer. Sales are recorded net of an allowance for sales returns and sales programs. Sales returns are estimated based upon historical returns, current economic trends, changes in customer demands and sell-through of products. The Company also records estimated reductions to revenue for sales programs such as incentive offerings. Sales program accruals are estimated based upon the attributes of the sales program, management’s forecast of future product demand, and historical customer participation in similar programs. If the actual costs of sales returns and sales programs significantly exceed the recorded estimated allowance, the Company’s sales would be significantly adversely affected.

The Company’s accounts receivable balance is recorded net of an allowance for estimated losses resulting from the failure of its customers to make required payments. An estimate of uncollectible amounts is made by management based upon historical bad debts, current customer receivable balances, age of customer receivable balances, the customer’s financial condition and current economic trends. If the actual uncollected amounts significantly exceed the estimated allowance, then the Company’s operating results would be significantly adversely affected.

Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out (FIFO) method. The inventory balance, which includes material, labor and manufacturing overhead costs, is recorded net of an estimated allowance for obsolete or unmarketable inventory. The estimated allowance for obsolete or unmarketable inventory is based upon management’s understanding of market conditions and forecasts of future product demand. If the actual amount of obsolete or unmarketable inventory significantly exceeds the estimated allowance, the Company’s cost of sales, gross profit and net income would be significantly adversely affected.

In the normal course of business, the Company acquires tangible and intangible assets. The Company periodically evaluates the recoverability of the carrying amount of its long-lived assets (including property, plant and equipment, goodwill and other intangible assets) whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. An impairment is assessed when the undiscounted future cash flows estimated to be derived from an asset are less than its carrying amount. Impairments are recognized in operating earnings. The Company uses its best judgment based on the most current facts and circumstances surrounding its business when applying these impairment rules to determine the timing of the impairment test, the undiscounted cash flows used to assess impairments, and the fair value of a potentially impaired asset. Changes in assumptions used could have a significant impact on the Company’s assessment of recoverability.

The Company has a stated two-year warranty policy for its Callaway Golf clubs, although the Company’s historical practice has been to honor warranty claims well after the two-year stated warranty period. 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. If the number of actual warranty claims or the cost of satisfying warranty claims significantly exceeds the estimated warranty reserve, the Company’s cost of sales, gross profit and net income would be significantly adversely affected.

Current income tax expense is the amount of income taxes expected to be payable for the current year. A deferred income tax asset or liability is established for the expected future consequences resulting from temporary differences in the financial reporting and tax bases of assets and liabilities. The Company provides a valuation allowance for its deferred tax assets when, in the opinion of management, it is more likely than not that such assets will not be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or

During the latter part of 2003, Callaway Golf Company completed the acquisition of substantially all of the golf-related assets of the Top-Flite Golf Company. Therefore, the results reported for the three and nine months ended September 30, 2003 are primarily representative of the Callaway Golf and Odyssey brand operations, but also include 15 days of Top-Flite Golf operating results in the United States.

Net sales decreased 16% to $128.5 million for the three months ended September 30, 2004 as compared to $153.6 million for the comparable period in the prior year. The overall decrease in net sales was primarily due to a $60.9 million (48%) decrease in the sales of golf clubs partially offset by a $27.1 million (191%) increase in the sales of golf balls in the third quarter of 2004 as compared to the third quarter of 2003. The decrease in golf club sales was primarily due to a decline in Callaway Golf woods and irons and Odyssey putters as a result of lower sales volumes and declines in average selling prices. This decline was partially offset by a $12.5 million increase in Top-Flite and Ben Hogan golf club sales during the third quarter of 2004 as compared to the same period in 2003, resulting from the inclusion of sales for a full three months in 2004 compared to two weeks in 2003. The increase in golf ball sales was primarily due to the $20.7 million increase in Top-Flite and Ben Hogan golf ball sales also resulting from the inclusion of sales for a full three months in 2004 compared to two weeks in 2003. In addition, as compared to 2003, the translation of foreign currency sales into U.S. dollars for reporting purposes had a $3.8 million positive impact upon net sales for the third quarter of 2004, as measured by applying 2003 exchange rates to 2004 reported net sales.

Net sales information by product category is summarized as follows (in millions):


^(*)	Beginning with the first quarter of 2004, the Company includes wedge sales with iron sales. Previously, wedge sales were included as a component of the accessories and other category and prior periods have been reclassified to conform with the current period presentation.

The $29.7 million (67%) decrease in net sales of woods to $14.3 million was primarily due to a decrease in sales of titanium and steel woods, partially offset by sales of the Company’s new fusion woods (woods comprised of multi-materials that are fused together). The overall decline in sales of woods during the quarter was primarily attributable to lower sales volumes combined with lower average selling prices as a result of increased competitive pressures.

The $19.8 million (35%) decrease in net sales of irons to $36.3 million was primarily due to the decline in sales of the Callaway Golf irons. This decline was expected as the Company’s higher priced steel iron products were in their second year of their product life cycle and such products generally sell better in the first year after introduction. The overall decrease was partially offset by the increase in sales of Top-Flite and Ben Hogan iron sales generated from a full quarter of sales in 2004 as compared to two weeks of sales in 2003.

The $11.4 million (42%) decrease in net sales of putters to $15.6 million is attributable to decreased sales of the Company’s Odyssey White Hot 2-ball putter (which is in its third year of sales) and DFX line of Odyssey putters, partially offset by the introduction of new putter products and the inclusion of a full quarter of sales of Top-Flite and Ben Hogan putters.

The $27.1 million (191%) increase in net sales of golf balls to $41.2 million was primarily attributable to the inclusion of a full quarter of sales of the Top-Flite and Ben Hogan golf ball products. Sales of the Top-Flite and Ben Hogan brand golf balls were $26.1 million for the three months ended September 30, 2004. Callaway Golf ball sales during the third quarter of 2004 were $15.1 million, an increase of $1.0 million (7%) from the third quarter of 2003.

The $8.7 million (70%) increase in sales of accessories and other products was primarily attributable to sales of pre-owned products through the recently acquired FrogTrader business combined with sales of Top-Flite and Ben Hogan bags, gloves and other accessories.

Net sales in the United States decreased $6.3 million (8%) to $71.4 million during the third quarter of 2004 as compared to the third quarter of 2003. The Company’s net sales in regions outside of the United States decreased $18.8 million (25%) during the third quarter of 2004 to $57.1 million versus the same period in 2003. The decline in the United States and the regions outside of the United States was primarily attributable to lower sales volumes and declines in average selling prices as a result of increased competitive pressures. These declines were partially offset by the inclusion of sales of Top-Flite and Ben Hogan products in the amount of $27.1 million in the United States and $11.6 million in regions outside of the United States. In addition, as compared to 2003, the Company’s 2004 reported net sales in regions outside of the United States were positively affected by the translation of foreign currency sales into U.S. dollars based upon 2004 exchange rates. As compared to 2003, the translation of foreign currency sales into U.S. dollars for reporting purposes had a $3.8 million positive impact upon net sales for the third quarter of 2004, as measured by applying 2003 exchange rates to 2004 reported net sales.

For the third quarter of 2004, gross profit decreased $44.1 million to $26.1 million from $70.2 million in the third quarter of 2003. Gross profit as a percentage of net sales decreased to 20% of net sales in the third quarter of 2004 from 46% in the comparable period of 2003. This decline in the Company’s gross profit percentage was primarily attributable to lower sales volumes, lower average selling prices as a result of increased competitive pressures, and the costs related to the integration of the Top-Flite and Callaway Golf operations, partially offset by improved margins on the Callaway Golf ball business.

Selling expenses increased $10.8 million (23%) to $58.3 million in the third quarter of 2004 as compared to $47.5 million in the comparable period of 2003. As a percentage of sales, the expenses increased to 45% in the third quarter of 2004 from 31% in the third quarter of 2003. The dollar increase in expenses in the third quarter of 2004 was primarily due to the $11.3 million increase in Top-Flite selling expenses resulting from the inclusion of a full quarter of Top-Flite selling expenses in 2004 as compared to two weeks of selling expenses in 2003.

General and administrative expenses increased $8.5 million (58%) in the third quarter of 2004 to $23.2 million from $14.7 million in the third quarter of 2003. As a percentage of sales, the expenses increased to 18% in the third quarter of 2004 from 10% in the third quarter of 2003. The dollar increase was primarily due to the $4.2 million increase in Top-Flite general and administrative expenses resulting from the inclusion of a full quarter of Top-Flite general and administrative expenses in 2004 as compared to two weeks of general and administrative expenses in 2003, as well as a $2.5 million increase in legal fees primarily related to the Dunlop/ Maxfli litigation.

Research and development expenses increased $0.2 million (2%) in the third quarter of 2004 to $7.9 million from $7.7 million in the comparable period of 2003. As a percentage of sales, the expenses increased slightly to 6% from 5% in the prior year. The dollar increase was primarily due to the increase in Top-Flite research and development expenses of $1.2 million partially offset by a $0.4 million decline in consulting expenses.

Other income remained consistent at $1.1 million in the third quarter of 2004 as compared to the third quarter of 2003. This is primarily attributable to a $1.5 million increase in foreign currency transaction gains partially offset by a $0.2 million increase in foreign currency contract losses, a $0.6 million decrease attributable to a legal settlement received in 2003, a $0.3 million decrease in interest income and a $0.2 million increase in Top-Flite other expense.

During the third quarter of 2004, the Company recorded a $26.3 million benefit from income taxes as compared to a $0.9 million benefit for the comparable period of 2003. The income tax benefit in 2004 was primarily attributable to a loss in the third quarter of 2004, the positive impact of settlements reached with taxing authorities, and adjustments as a result of the Company’s finalization of its U.S. income tax return for 2003. The income tax benefit in 2003 was primarily attributable to a one-time export tax benefit in 2003 for certain prior year tax years.

Net loss for the third quarter of 2004 was $35.9 million as compared to net income of $2.3 million in the comparable period in 2003. Diluted loss per share for the third quarter of 2004 was $0.53 as compared to diluted earnings per share of $0.03 in the comparable period of 2003. Net loss and diluted loss per share in 2004 were negatively affected by after-tax charges relating to the integration of the Callaway Golf and Top-Flite operations in the amount of $4.4 million and $0.07 per share, respectively. Excluding these integration charges, (i) net loss would have been $31.5 million and (ii) diluted loss per share would have been $0.46 per share for the third quarter of 2004.

In order to assist with period over period comparisons of the Callaway Golf business and to provide additional insight into the effect that the acquisition and integration of the Top-Flite business had on the


^(*)	During the latter part of 2003, Callaway Golf Company completed the acquisition of substantially all of the golf-related assets of the Top-Flite Golf Company. Therefore, the results reported for the quarter ended September 30, 2003 are primarily representative of the Callaway Golf and Odyssey brand operations, but also include 15 days of Top-Flite Golf operating results in the United States.

Net sales increased 18% to $790.2 million for the nine months ended September 30, 2004 as compared to $667.4 million for the comparable period in the prior year. The overall increase in net sales is primarily due to a $144.4 million (333%) increase in the sales of golf balls combined with a $38.0 million (77%) increase in sales of the Company’s accessories and other products. The significant increase in golf ball sales was due to the $112.2 million increase in net sales of Top-Flite and Ben Hogan golf ball products resulting from the inclusion of sales for a full nine months in 2004 as compared to two weeks in 2003 and a $32.2 million improvement in Callaway Golf brand golf ball sales. These increases were partially offset by a $36.4 million (31%) decrease in sales of putters and a $22.9 million (9%) decrease in sales of irons for the first nine months of 2004, as compared to the same period in 2003. As compared to the first nine months of 2003, the translation of foreign currency sales into U.S. dollars for reporting purposes had a $29.1 million positive impact upon net sales for the first nine months of 2004, as measured by applying 2003 exchange rates to 2004 reported net sales.

As compared to the first nine months of 2003, the Company’s net sales for the first nine months of 2004 were significantly affected by the inclusion of $175.6 million in sales of Top-Flite and Ben Hogan branded products. Excluding sales of Top-Flite and Ben Hogan branded products, sales of Callaway Golf and Odyssey branded products were $614.6 million for the first nine months of 2004, a $47.5 million (7%) decrease as compared to the first nine months of 2003. This decrease is primarily due to a decline in sales volumes due to a decrease in sales of products that were in their second and third years of their product life cycles as well as a decline in average selling prices as a result of increased competitive pressures.

Net sales information by product category is summarized as follows (in millions):


^(*)	Beginning with the first quarter of 2004, the Company includes wedge sales with iron sales. Previously, wedge sales were included as a component of the accessories and other category and prior periods have been reclassified to conform with the current period presentation.

The $0.3 million (0%) decrease in net sales of woods to $213.6 million was primarily due to a decrease in titanium woods offset by an increase in sales of the Company’s new fusion woods products and steel products. The decrease in sales of titanium woods is primarily due to increased competitive pressures resulting in a decline in units sold as well as lower average selling prices. The increase in fusion and steel woods was due to new product introductions.

The $22.9 million (9%) decrease in net sales of irons to $219.8 million was due primarily to a decline in sales of the Callaway Golf irons. This decline was expected as the Company’s higher priced steel iron products were in their second year of their product life cycle and such products generally sell better in the first year after introduction. The overall decrease was partially offset by the increase in sales of Top-Flite and Ben Hogan iron sales generated from a full nine months of sales in 2004 as compared to two weeks of sales in 2003.

The $36.4 million (31%) decrease in net sales of putters to $81.7 million was attributable to decreased sales of the Company’s Odyssey White Hot 2-ball putter (which is in its third year of sales) and DFX line of Odyssey putters, partially offset by the introduction of new putter products and the inclusion of a full nine months of sales of Top-Flite and Ben Hogan putters.

The $144.4 million (333%) increase in net sales of golf balls to $187.8 million was primarily attributable to the inclusion of sales of the Top-Flite and Ben Hogan golf ball products for a full nine months in 2004 as compared to two weeks in 2003, as well as strong sales for the newly released Callaway Golf balls. Sales of the Top-Flite and Ben Hogan brand golf balls were $116.7 million for the nine months ended September 30, 2004. Callaway Golf ball sales during the first nine months of 2004 were $71.1 million, an increase of $27.6 million (64%) from the first nine months of 2003. The increase in Callaway Golf ball sales during the first nine months of 2004 were positively affected by the addition of two new products to the product line for the current year and the absence of any new Callaway Golf ball product introductions in the first nine months of 2003.

The $38.0 million (77%) increase in sales of accessories and other products is primarily attributable to sales of Top-Flite and Ben Hogan bags, gloves and other accessories and sales of pre-owned products through the recently acquired FrogTrader business combined with an increase in sales of Callaway Golf shoes, travel bags and other accessories.

Net sales in the United States increased $90.2 million (24%) to $460.4 million during the first nine months of 2004 versus the first nine months of 2003. The Company’s sales in regions outside of the United States increased $32.6 million (11%) to $329.8 million during the first nine months of 2004 versus the same period of 2003. The increase in the United States and the regions outside of the United States was primarily attributable to the inclusion of Top-Flite and Ben Hogan sales for a full nine months in 2004 in the amount of $114.7 million in the United States and $60.9 million in regions outside of the United States. In addition, as compared to 2003, the Company’s 2004 reported net sales in regions outside of the United States were affected by the translation of foreign currency sales into U.S. dollars based upon 2004 exchange rates. As compared to 2003, the translation of foreign currency sales into U.S. dollars for reporting purposes had a $29.2 million positive impact upon net sales for the first nine months of 2004, as measured by applying 2003 exchange rates to 2004 reported net sales.

For the nine months ended September 30, 2004, gross profit decreased $14.5 million to $320.1 million from $334.6 million in the comparable period of 2003. Gross profit as a percentage of net sales decreased to 41% of net sales in the first nine months of 2004 from 50% in the comparable period of 2003. This decline in the Company’s gross profit percentage was primarily attributable to lower average selling prices as a result of increased competitive pressures and close-out products, lower margins in the Top-Flite business (as compared to the Callaway Golf business), lower sales volumes and the costs related to the integration of the Top-Flite and Callaway Golf operations, partially offset by improved margins on the Callaway Golf ball business.

Selling expenses increased $54.5 million (36%) in the first nine months of 2004 to $204.0 million from $149.5 million in the comparable period of 2003, and were 26% and 22% of net sales, respectively. The increase in expenses was primarily due to the $48.2 million increase in Top-Flite selling expenses resulting from the inclusion of a full nine months of Top-Flite selling expenses in 2004 as compared to two weeks of selling expenses in 2003. The increase was also due to an $11.1 million increase in Callaway Golf tour and promotional expenses, partially offset by a $7.6 million decrease in Callaway Golf advertising expenses. The majority of the increase in tour and promotional expenses was incurred during the first half of the year, primarily as a result of the Company’s strategy to increase its presence on golf’s major professional tours.

General and administrative expenses increased $24.8 million (57%) in the first nine months of 2004 to $67.9 million from $43.2 million in the first nine months of 2003. As a percentage of sales, the expenses increased to 9% in the first nine months of 2004 from 6% in the first nine months of 2003. The dollar increase was primarily due to the $16.3 million increase in Top-Flite general and administrative expenses resulting from the inclusion of a full nine months of Top-Flite general and administrative expenses in 2004 as compared to two weeks of general and administrative expenses in 2003, as well as a $4.2 million increase in legal fees primarily related to the Dunlop/Maxfli litigation and a $2.1 million increase in employee costs primarily related to severance costs.

Research and development expenses increased $2.9 million (14%) in the first nine months of 2004 to $23.5 million from $20.6 million in the comparable period of 2003. As a percentage of sales, the expenses remained consistent at 3.0%. The dollar increase was primarily due to the $3.4 million increase in Top-Flite

Other expense increased to $0.2 million in the first nine months of 2004 as compared to other income of $1.3 million in the first nine months of 2003. The $1.5 million of additional other expense is primarily attributable to a $5.5 million decrease in foreign currency transaction gains partially offset by a $4.7 million decrease in foreign currency contract losses.

During the first nine months of 2004, the Company recorded a provision for income taxes of $6.1 million as compared to a provision for income taxes of $43.6 million for the comparable period of 2003. The provision for income tax as a percentage of income before taxes was 25% in 2004 as compared to 36% in 2003. The 2004 tax rate was positively impacted by the resolution of certain prior tax audits. The 2003 tax rate was positively impacted by a one-time export tax benefit.

Net income for the first nine months of 2004 decreased 77% to $18.4 million from $79.0 million in the comparable period in 2003. Diluted earnings per share for the first nine months of 2004 decreased 77% to $0.27 from $1.19 in the comparable period in 2003. Net income and diluted earnings per share in 2004 were negatively affected by after-tax charges relating to the integration of the Callaway Golf and Top-Flite operations in the amount of $14.3 million and $0.20 per share, respectively. Excluding these integration charges, as compared to the first nine months of 2003, for the first nine months of 2004, (i) net income would have increased to $32.7 million and (ii) diluted earnings per share would have decreased to $0.47 per share.

In order to assist with period over period comparisons of the Callaway Golf business and to provide additional insight into the effect that the acquisition and the integration of the Top-Flite business had on the Company’s results, the Company has provided the following reconciling information in accordance with Regulation G (in thousands, except per share data):


^(*)	During the latter part of 2003, Callaway Golf Company completed the acquisition of substantially all of the golf-related assets of the Top-Flite Golf Company. The results reported for the nine month period ended September 30, 2003 are primarily representative of the Callaway Golf and Odyssey brand operations, but also include 15 days of Top-Flite Golf operating results in the United States.

Cash and cash equivalents increased $20.2 million (43%) to $67.5 million at September 30, 2004, from $47.3 million at December 31, 2003. The overall increase in cash primarily resulted from cash provided by

operating activities of $46.1 million partially offset by cash used in investing activities of $24.8 million and cash used in financing activities of $1.9 million. Cash flows provided by operating activities for the nine months ended September 30, 2004, reflect net income of $18.4 million, adjusted for depreciation and amortization of $39.0 million and a $26.1 million decrease in inventory. These cash inflows were partially offset by a net $13.7 million increase in accounts receivable, and a $39.2 million decrease in income taxes payable. Cash flows used in investing activities reflect the FrogTrader business acquisition (net of acquired cash) of $9.2 million and capital expenditures of $16.1 million. Cash flows used in financing activities are primarily attributable to the $14.2 million payment of dividends and the acquisition of treasury stock in the amount of $6.3 million partially offset by $18.6 million of proceeds from the issuance of common stock in connection with the exercise of employee stock options and purchases under the employee stock purchase plan.

At September 30, 2004, the Company’s net accounts receivable increased $14.2 million to $114.9 million from $100.7 million at December 31, 2003. The growth in receivables is primarily due to the general seasonality of the business (see below “Certain Factors Affecting Callaway Golf Company — Seasonality and Adverse Weather Conditions”). The Company’s net accounts receivable decreased $21.5 million at September 30, 2004 as compared to the Company’s net accounts receivable at September 30, 2003. This decrease is attributable to the overall decrease in sales for the quarter ended September 2004.

At September 30, 2004, the Company’s net inventory decreased $23.9 million to $161.5 million from $185.4 million at December 31, 2003. The decrease is consistent with seasonal trends (see below “Certain Factors Affecting Callaway Golf Company — Seasonality and Adverse Weather Conditions”). The Company’s net inventory increased $20.3 million as of September 30, 2004 as compared to the Company’s net inventory as of September 30, 2003. This increase is primarily attributable to an $18.1 million increase in Top-Flite net inventory. The Top-Flite inventory balance at September 30, 2003 consisted only of the U.S. portion of the inventory that was acquired in conjunction with the Top-Flite acquisition. All foreign inventory was acquired during the fourth quarter of 2003.

At September 30, 2004, the Company’s net property, plant and equipment decreased $25.1 million to $139.7 million from $164.8 million at December 31, 2003. This decrease is primarily due to depreciation of $36.5 million during the first nine months of 2004 and asset disposals of $4.3 million, partially offset by asset additions of $16.1 million during the same period.

The Company’s principal sources of liquidity are cash flows provided by operations and the Company’s credit facilities in effect from time to time. The Company currently expects this to continue. At September 30, 2004, the Company had a $100 million revolving line of credit with Bank of America and certain other lenders (the “2003 Line of Credit”). At September 30, 2004, there were no borrowings outstanding under the 2003 Line of Credit. The 2003 Line of Credit was scheduled to expire by its terms on November 9, 2004.

Effective November 5, 2004, the Company amended and restated the 2003 Line of Credit to provide for a new five year revolving line of credit from Bank of America, N.A. and certain other lenders, providing for revolving loans of up to $300 million, of which $250 million consisted of commitments available at the closing and the balance of which are available to the Company upon the satisfaction of certain conditions. Actual borrowing availability under the new credit facility is limited effectively by the financial covenants set forth in the new credit facility. As of the date of this report, the maximum amount that could be borrowed under the new credit facility was approximately $134 million. As of the date of this report, no borrowings were outstanding under the new credit facility and the Company was in compliance with the covenants and other terms thereof. See Note 7 to the Company’s Consolidated Condensed Financial Statements for further details concerning the Company’s new line of credit.

During the nine months ended September 30, 2004, the Company repurchased 353,000 shares of Callaway Golf common stock at a cost of $6.3 million. There were no repurchases of equity securities during the quarter ended September 30, 2004. All repurchases during the year were made pursuant to the $50.0 million stock repurchase program authorized and announced by the Board of Directors in May 2002. As of September 30, 2004 the remaining authority under this program authorizes the Company to repurchase approximately $8.0 million of Company stock.

The following table provides, as of September 30, 2004 certain significant cash and contractual obligations that will affect the Company’s future liquidity (in millions):


⁽¹⁾	The Company leases certain warehouse, distribution and office facilities, vehicles as well as office equipment under operating leases. The amounts presented in this line item represent commitments for minimum lease payments under non-cancelable operating leases and include operating leases assumed as part of the Top-Flite Acquisition.

⁽²⁾	The Company acquired certain capital lease obligations as a result of the Top-Flite Acquisition primarily related to computer and telecommunications systems. The amounts presented in this line item represent commitments for minimum lease payments under non-cancelable capital leases.

⁽³⁾	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. The amounts listed are the approximate amounts of the minimum purchase obligations, base compensation, and guaranteed minimum royalty payments the Company is obligated to pay under these agreements. The actual amounts paid under some of these agreements may be higher or lower than the amounts included. In the aggregate, the actual amounts paid under these obligations is likely to be higher than the amounts listed as a result of the variable nature of these obligations. 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 line item.

⁽⁴⁾	The amounts presented in this line item represent the liability for the Company’s unfunded, non-qualified deferred compensation plan. The plan allows officers, certain other employees and directors of the Company to defer all or part of their compensation, to be paid to the participants or their designated beneficiaries after retirement, death or separation from the Company. To support the deferred compensation plan, the Company has elected to purchase Company-owned life insurance. The cash surrender value


	of the Company-owned insurance related to deferred compensation is included in other assets and was $8.9 million at September 30, 2004.

⁽⁵⁾	During the third quarter of 2001, the Company entered into a derivative commodity instrument to manage electricity costs in the volatile California energy market. The contract was originally effective through May 2006. During the fourth quarter of 2001, the Company notified the energy supplier that, among other things, the energy supplier was in default of the energy supply contract and that based upon such default and for other reasons, the Company was terminating the energy supply contract. The Company continues to reflect the $19.9 million derivative valuation account on its balance sheet, subject to periodic review, in accordance with SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The $19.9 million represents unrealized losses resulting from changes in the estimated fair value of the contract and does not represent contractual cash obligations. The Company believes the energy supply contract has been terminated and, therefore, the Company does not have any further cash obligations under the contract. Accordingly, the energy derivative valuation account is not included in the table. There can be no assurance, however, that a party will not assert a future claim against the Company or that a bankruptcy court or arbitrator will not ultimately nullify the Company’s termination of the contract. No provision has been made for contingencies or obligations, if any, under the contract beyond November 2001. See below “Supply of Electricity and Energy Contracts.”

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 products 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 claims based on the negligence or willful misconduct of the Company and (iv) indemnities involving the accuracy of representations and warranties in certain contracts. The Company also 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 a guarantee in the form of a standby letter of credit as security for contingent liabilities under certain workers’ compensation insurance policies. 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 will be required under the commitments and guarantees described above. The fair value of indemnities, commitments and guarantees that the Company issued during the nine months ended September 30, 2004 was not material to the Company’s financial position, results of operations or cash flows.

In addition to the cash and contractual obligations listed above, the Company’s liquidity could also be adversely affected by an unfavorable outcome with respect to claims and litigation that the Company is subject to from time to time. See below “Part II, Item I — Legal Proceedings.”

Based upon its current operating plan, analysis of its consolidated financial position and projected future results of operations, the Company believes that its operating cash flows, together with its new credit facility, will be sufficient to finance current operating requirements, planned capital expenditures, contractual obligations and commercial commitments, for the next twelve months. There can be no assurance, however, that future industry specific or other developments, general economic trends or other matters will not adversely affect the Company’s operations or its ability to meet its future cash requirements. See below “Certain Factors Affecting Callaway Golf Company.”

Beginning in the summer of 2000, the Company identified a future risk to ongoing operations as a result of the deregulation of the electricity market in California. In July 2000, the Company entered into a one-year supply agreement with Idaho Power Company (“Idaho Power”), a subsidiary of Idacorp, Inc., for the supply of electricity at $64 per megawatt hour. During the second quarter of 2001, Idaho Power advised the Company that it was unwilling to renew the contract upon expiration in July 2001 due to concerns surrounding the volatility of the California electricity market at that time.

As a result, in the second quarter of 2001, the Company entered into an agreement with Pilot Power Group, Inc. (“Pilot Power”) as the Company’s energy service provider and in connection therewith entered into a long-term, fixed-priced, fixed-capacity, energy supply contract (“Enron Contract”) with Enron Energy Services, Inc. (“EESI”), a subsidiary of Enron Corporation, as part of a comprehensive strategy to ensure the uninterrupted supply of electricity while capping costs in the volatile California electricity market. The Enron Contract provided, subject to the other terms and conditions of the contract, for the Company to purchase nine megawatts of energy per hour from June 1, 2001 through May 31, 2006 (394,416 megawatts over the term of the contract). The total purchase price for such energy over the full contract term would have been approximately $43.5 million.

Because the Enron Contract provided for the Company to purchase an amount of energy in excess of what it expected to be able to use in its operations, the Company accounted for the Enron Contract as a derivative instrument in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The Enron Contract did not qualify for hedge accounting under SFAS No. 133. Therefore, the Company recognized changes in the estimated fair value of the Enron Contract currently in earnings. The estimated fair value of the Enron Contract was based upon a present value determination of the net differential between the contract price for electricity and the estimated future market prices for electricity as applied to the remaining amount of unpurchased electricity under the Enron Contract. Through September 30, 2001, the Company had recorded unrealized pre-tax losses of $19.9 million.

On November 30, 2001, EESI notified the Company that it disagreed that it was in default of the Enron Contract and that it was prepared to deliver energy pursuant to the Enron Contract. However, on December 2, 2001, EESI, along with Enron Corporation and numerous other related entities, filed for bankruptcy. Since November 30, 2001, the parties have not been operating under the Enron Contract and Pilot Power has been providing energy to the Company from alternate suppliers.

As a result of the Company’s notice of termination to EESI, and certain other automatic termination provisions under the Enron Contract, the Company believes that the Enron Contract has been terminated. As a result, the Company adjusted the estimated value of the Enron Contract through the date of termination, at which time the terminated Enron Contract ceased to represent a derivative instrument in accordance with SFAS No. 133. Because the Enron Contract is terminated and neither party to the contract is performing pursuant to the terms of the contract, the Company no longer records future valuation adjustments for changes in electricity rates. The Company continues to reflect on its balance sheet the derivative valuation account of $19.9 million, subject to periodic review, in accordance with SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.”

The Company believes the Enron Contract has been terminated, and as of October 31, 2004, EESI has not asserted any claim against the Company. There can be no assurance, however, that EESI or another party will not assert a future claim against the Company or that a bankruptcy court or arbitrator will not ultimately nullify the Company’s termination of the Enron Contract. No provision has been made for contingencies or obligations, if any, under the Enron Contract beyond November 30, 2001.

The financial statements contained in this report and the related discussion describe and analyze the Company’s financial performance and condition for the periods presented. For the most part, this information is historical. The Company’s prior results, however, are not necessarily indicative of the Company’s future performance or financial condition. The Company has also included certain forward-looking statements concerning the Company’s future performance or financial condition. These forward-looking statements are based upon current information and expectations and actual results could differ materially. The Company therefore has included the following discussion of certain factors that could cause the Company’s future performance or financial condition to differ materially from its prior performance or financial condition or from management’s expectations or estimates of the Company’s future performance or financial condition. These factors, among others, should be considered in assessing the Company’s future prospects and prior to making an investment decision with respect to the Company’s stock.

In September 2003, the Company acquired through a court-approved sale substantially all of the golf-related assets of the TFGC Estate Inc. (f/k/a The Top-Flite Golf Company, f/k/a Spalding Sports Worldwide, Inc.), which included golf ball manufacturing facilities, the Top-Flite and Ben Hogan brands, and all golf-related patents and trademarks. The Company faces certain challenges associated with this acquisition, including (i) reinvigorating the Top-Flite brands in the marketplace, (ii) the assimilation of the Top-Flite and Callaway Golf brands in the marketplace without negatively affecting the sales of either brand, (iii) the integration and consolidation of the Callaway Golf and Top-Flite golf ball manufacturing operations, (iv) the ability to maintain good customer relations and service as the Company integrates international Top-Flite sales and distribution operations with the Company’s existing foreign subsidiaries, (v) operating all or almost all of the golf ball manufacturing operations in a mature facility that is located in a harsh climate across the country from the Company’s principal executive offices and that has a unionized workforce, and (vi) the employee and other issues inherent in any consolidation. Furthermore, the integration and consolidation of the acquired assets will require a considerable amount of time and attention of senior management and others, which could have an adverse effect upon the Company’s club business.

In addition, in connection with the integration and consolidation of the golf ball manufacturing operations, the Company has incurred and expects to incur additional significant charges to earnings. During the fourth quarter of 2003, the Company recorded a charge of approximately $0.25 per share related to the disposal of certain golf ball manufacturing equipment. During the first nine months of 2004, the Company incurred additional pre-tax integration charges in the amount of approximately $23.3 million and on October 19, 2004 the Company announced that the total integration charges for 2004 (including the charges incurred during the first nine months) are estimated to be approximately $30 million. Additional integration charges in the amount of approximately $5 million to $10 million are estimated to be incurred in 2005.

Finally, the Company has spent a considerable amount of cash to complete the Top-Flite Acquisition and there is no assurance that the Company will realize a satisfactory return on its investment.

Terrorist activities and armed conflicts in recent years (such as the attacks on the World Trade Center and the Pentagon, the incidents of Anthrax poisoning and the military actions in the Middle East, including the war in Iraq), as well as the threat of future conflict, have had a significant adverse effect upon the Company’s business. Any such additional events would likely have an adverse effect upon the world economy

and would likely adversely affect the level of demand for the Company’s products as consumers’ attention and interest are diverted from golf and become focused on these events and the economic, political, and public safety issues and concerns associated with such events. Also, such events could adversely affect the Company’s ability to manage its supply and delivery logistics. If such events caused a significant disruption in domestic or international air, ground or sea shipments, the Company’s ability to obtain the materials necessary to produce and sell its products and to deliver customer orders also would be materially adversely affected. Furthermore, such events have negatively impacted tourism, and if this negative impact upon tourism continues, the Company’s sales to retailers at resorts and other vacation destinations would be materially adversely affected.

The outbreak of a pandemic disease, such as Severe Acute Respiratory Syndrome (“SARS”) or the Avian Flu, could significantly adversely affect the Company’s business. A pandemic disease could significantly adversely affect both the demand for the Company’s products as well as the supply of the components used to make the Company’s products. Demand for golf products could be negatively affected as consumers in the affected regions restrict their recreational activities and as tourism to those areas declines. Moreover, the Company relies on many companies in Asia for its components. If the Company’s suppliers experienced a significant disruption in their business as a result of a pandemic disease, the Company’s ability to obtain the necessary components to make its products could be significantly adversely affected. In addition, the outbreak of any such disease generally restricts the travel to and from such countries making it more difficult in general to manage the Company’s international operations.

The Company sells golf clubs, golf balls and golf accessories. These products are recreational in nature and are therefore discretionary purchases for consumers. Consumers are generally more willing to make discretionary purchases of golf products during favorable economic conditions and when consumers are feeling confident and prosperous. Adverse economic conditions in the United States or in the Company’s international markets (which represent almost half of the Company’s total sales), or a decrease in prosperity among consumers, or even a decrease in consumer confidence as a result of anticipated adverse economic conditions, could cause consumers to forgo or to postpone purchasing new golf products. Such forgone or postponed purchases could have a material adverse effect upon the Company.

Almost half of the Company’s sales are international sales. As a result, the Company conducts transactions in approximately 12 currencies worldwide. Conducting business in such various currencies increases the Company’s exposure to fluctuations in foreign currency exchange rates relative to the U.S. dollar. Changes in exchange rates may positively or negatively affect the Company’s financial results. Overall, the Company is generally negatively affected by a stronger U.S. dollar in relation to the foreign currencies in which the Company conducts business. Conversely, overall, the Company is generally positively affected by a weaker U.S. dollar relative to such foreign currencies. For the effect of foreign currencies on the Company’s financial results for the current reporting periods, see above “Results of Operations.”

The effects of foreign currency fluctuations can be significant. The Company therefore engages in certain hedging activities to mitigate the impact of foreign currency fluctuations over time on the Company’s financial results. The Company’s hedging activities reduce, but do not eliminate, the effects of such foreign currency fluctuations. Factors that could affect the effectiveness of the Company’s hedging activities include accuracy of sales forecasts, volatility of currency markets and the availability of hedging instruments. Since the hedging activities are designed to reduce volatility, they not only reduce the negative impact of a stronger U.S. dollar but they also reduce the positive impact of a weaker U.S. dollar. For the effect of the Company’s hedging activities during the current reporting periods, see below “Quantitative and Qualitative Disclosures about Market Risk.”

The Company’s future financial results could be significantly negatively affected if the value of the U.S. dollar increases relative to the foreign currencies in which the Company conducts business. The degree to which the Company’s financial results are affected will depend in part upon the effectiveness or ineffectiveness of the Company’s hedging activities.

Golf Clubs. In order for the Company to significantly grow its sales of golf clubs, the Company must either increase its share of the market for golf clubs or the market for golf clubs must grow. The Company already has a significant share of worldwide premium golf club sales and therefore opportunities for additional market share may be limited. The Company does not believe there has been any material increase in the number of golfers in the United States in over four years. Furthermore, the Company believes that since 1997 overall worldwide premium golf club sales have generally not experienced substantial growth in dollar volume from year to year. There is no assurance that the overall dollar volume of worldwide premium golf club sales will grow, or that it will not decline, in the future.

Golf Balls. In connection with the acquisition of the Top-Flite assets, the Company significantly increased its golf ball market share. Prior to the acquisition, however, both Callaway Golf’s and Top-Flite’s market shares had been declining. The Company’s ability to reverse such decline and to obtain the market share previously enjoyed will depend in part upon the Company’s ability to integrate the Top-Flite brands and operations with the Callaway Golf brands and operations. There is no assurance that the Company will be able to successfully or profitably integrate these brands or operations or maintain the combined market share previously enjoyed by the Top-Flite and Callaway Golf brands.

The Company plans its manufacturing capacity based upon the forecasted demand for its products. Actual demand for such products may exceed or be less than forecasted demand. The Company’s unique product designs often require sophisticated manufacturing techniques, which can require significant start-up expenses and/or limit the Company’s ability to quickly expand its manufacturing capacity to meet the full demand for its products. If the Company is unable to produce sufficient quantities of new products in time to fulfill actual demand, especially during the Company’s traditionally busy season, it could limit the Company’s sales and adversely affect its financial performance. On the other hand, the Company invests in manufacturing capacity and commits to components and other manufacturing inputs for varying periods of time, which can limit the Company’s ability to quickly react if actual demand is less than forecasted demand. This could result in less than optimum capacity usage and/or in excess inventories and related obsolescence charges that could adversely affect the Company’s financial performance. In addition, if the Company were to experience delays, difficulties or increased costs in its production of golf clubs or golf balls, including production of new products needed to replace current products, the Company’s future golf club or golf ball sales could be adversely affected.

The Company’s golf club and golf ball manufacturing facilities in California use, among other resources, significant quantities of electricity to operate. In 2001, some companies in California, including the Company, experienced periods of blackouts during which electricity was not available. The Company has taken certain steps to provide access to alternative power supplies for certain of its operations, and believes that these measures could mitigate any impact resulting from possible future blackouts. The Company is currently purchasing for its California operations wholesale energy through the Company’s California energy service provider under short-term contracts. From time to time, legislation has been introduced that would restrict the Company’s ability to purchase wholesale energy through its energy service provider. If any such legislation were passed, the Company may be required to purchase energy from the local public utility, which could cause the Company’s cost of energy to increase. If the Company’s costs of energy were to increase as a result of such legislation or otherwise, the Company’s results of operations would be adversely affected.

The Company is dependent on a limited number of suppliers for its clubheads and shafts, some of which are single-sourced. In addition, some of the Company’s products require specifically developed manufacturing techniques and processes which make it difficult to identify and utilize alternative suppliers quickly. The Company believes that suitable clubheads and shafts could be obtained from other manufacturers in the event its regular suppliers (because of financial difficulties or otherwise) are unable or fail to provide suitable components. However, there could be a significant production delay or disruption caused by the inability of current suppliers to deliver or the transition to other suppliers, which in turn could have a material adverse impact on the Company’s results of operations. The Company is also single-sourced or dependent on a limited number of suppliers for the materials it uses to make its golf balls. Many of the materials are customized for the Company. Any delay or interruption in such supplies could have a material adverse impact upon the Company’s golf ball business. If the Company did experience any such delays or interruptions, there is no assurance that the Company would be able to find adequate alternative suppliers at a reasonable cost or without significant disruption to its business.

The Company uses United Parcel Service (“UPS”) for substantially all ground shipments of products to its U.S. customers. The Company uses air carriers and ships for most of its international shipments of products. Any significant interruption in UPS, air carrier or ship services could have a material adverse effect upon the Company’s ability to deliver its products to its customers. If there were any significant interruption in such services, there is no assurance that the Company could engage alternative suppliers to deliver its products in a timely and cost-efficient manner. In addition, many of the components the Company uses to build its golf clubs, including clubheads and shafts, are shipped to the Company via air carrier and ship services. Any significant interruption in UPS services, air carrier services or shipping services into or out of the United States could have a material adverse effect upon the Company (see also below “International Risks”).

The Company’s size has made it a large consumer of certain materials, including steel, titanium alloys, carbon fiber and rubber. The Company does not make these materials itself, and must rely on its ability to obtain adequate supplies in the world marketplace in competition with other users of such materials. While the Company has been successful in obtaining its requirements for such materials thus far, there can be no assurance that it always will be able to do so at a reasonable price. An interruption in the supply of the materials used by the Company or a significant change in costs could have a material adverse effect on the Company.

Golf Clubs. The golf club business is highly competitive, and is served by a number of well-established and well-financed companies with recognized brand names, as well as new companies with popular products. New product introductions, price reductions, consignment sales, extended payment terms and “close-outs” (including close-outs of products that were recently commercially successful) by competitors continue to generate increased market competition. Furthermore, continued price compression in the club industry for new clubs could have a significant adverse affect on the Company’s pre-owned club business as the gap between the cost of a new club and a pre-owned club lessens. There can be no assurance that successful marketing activities, discounted pricing, consignment sales, extended payment terms or new product introductions by competitors will not negatively impact the Company’s future sales.

Golf Balls. The golf ball business is also highly competitive and may be becoming even more competitive. There are a number of well-established and well-financed competitors, including one competitor with an estimated U.S. market share in excess of 50%. As competition in this business increases, many of these competitors are substantially discounting the prices of their products and/or increasing advertising, tour or other promotional support. This increased competition has resulted in significant expenses for the Company in both tour and advertising support and product development. Unless there is a change in competitive conditions, these pricing pressures and increased costs will continue to adversely affect the profitability of the Company’s golf ball businesses.

On a consolidated basis, no one customer that distributes the Company’s golf clubs or balls in the United States accounted for more than 4% of the Company’s revenues in 2003, 2002 or 2001. On a segment basis, the Company’s golf ball customer base is much more concentrated than its golf club customer base. In 2004, it is expected that the top five golf ball customers will account for over 25% of the Company’s total golf ball sales. A loss of one or more of these customers could have a significant adverse effect upon the Company’s golf ball sales.

A golf equipment manufacturer’s ability to compete is in part dependent upon its ability to satisfy the various subjective requirements of golfers, including a golf club’s and golf ball’s look and “feel,” and the level of acceptance that a golf club and ball has among professional and recreational golfers. The subjective preferences of golf club and ball purchasers are difficult to predict and may be subject to rapid and unanticipated changes. In addition, the Company’s products have tended to incorporate significant innovations in design and manufacture, which have often, but not always, resulted in higher prices for the Company’s products relative to other products in the marketplace. There can be no assurance that a significant percentage of the public will always be willing to pay premium prices for golf equipment or that the Company will be able to design and manufacture products that achieve market acceptance. In general, there can be no assurance as to whether or how long the Company’s golf clubs and golf balls will achieve and maintain market acceptance and therefore there can be no assurance that the demand for the Company’s products will permit the Company to experience growth in sales, or maintain historical levels of sales, in the future.

The Company believes that the introduction of new, innovative golf clubs and golf balls is important to its future success. A major portion of the Company’s revenues is generated by products that are less than two years old. The Company faces certain risks associated with such a strategy. For example, in the golf industry, new models and basic design changes in golf equipment are frequently met with consumer rejection. In addition, prior successful designs have been rendered obsolete within a relatively short period of time as new products are introduced into the marketplace. Further, any new products that retail at a lower price than prior products may negatively impact the Company’s revenues unless unit sales increase. The rapid introduction of new golf club or golf ball products by the Company has resulted in close-outs of existing inventories at both the wholesale and retail levels. Such close-outs have resulted in reduced margins on the sale of older products, as well as reduced sales of new products, given the availability of older products at lower prices.

The Company’s newly introduced golf club products generally, but not always, have a product life cycle of up to two years. These products generally sell significantly better in the first year after introduction as compared to the second year. In certain markets, such as Japan, the decline in sales occurs sooner in the product cycle and is more significant. The Company’s fusion woods generally sell at higher price points than its titanium metal woods, and its titanium metal woods generally sell at higher price points than its steel metal woods. Historically, the Company’s wood products generally have achieved better gross margins than its iron products. However, price compression in the woods market has made this differential less, and at times gross margins on woods may be less than other products. The Company’s sales and gross margins for a particular period may be negatively or positively affected by the mix of new products sold in such period.

In addition to the effects of product cycles described above, the Company’s business is also subject to the effects of seasonal fluctuations. The Company’s first quarter sales generally represent the Company’s sell-in to the golf retail channel of its golf club products for the new golf season. Orders for many of these sales are received during the fourth quarter of the prior year. The Company’s second and third quarter sales generally represent re-order business for golf clubs. Sales of golf clubs during the second and third quarters therefore are significantly affected not only by the sell-through of the Company’s products that were sold into the channel during the first quarter but also by the sell-through of the products of the Company’s competitors. The Company’s sales of golf balls are generally associated with the level of rounds played in the areas where the

Company’s products are sold. Therefore, golf ball sales tend to be greater in the second and third quarters, when the weather is good in most of these areas and rounds played are up. Golf ball sales are also stimulated by product introductions as the retail channel takes on initial supplies. Like golf clubs, re-orders of golf balls depend on the rate of sell-through. Retailers are sometimes reluctant to re-order the Company’s products in significant quantity when they already have excess inventory of the Company’s or its competitors’ products. The Company’s sales during the fourth quarter are generally significantly less than the other quarters because in general in many of the Company’s principal markets less people are playing golf during that time of year due to cold weather. Furthermore, it previously was the Company’s practice to announce its new product line at the beginning of each calendar year. The Company has departed from that practice and now generally announces its new product line in the fourth quarter to allow retailers to plan better. Such early announcements of new products could cause golfers, and therefore the Company’s customers, to defer purchasing additional golf equipment until the Company’s new products are available. Such deferments could have a material adverse effect upon sales of the Company’s current products and/or result in close-out sales at reduced prices.

Because of these seasonal trends, the Company’s business can be significantly adversely affected by unusual or severe weather conditions. Unfavorable weather conditions generally result in less golf rounds played, which generally results in less demand for golf clubs and golf balls. Furthermore, catastrophic storms, such as the recent hurricanes in Florida and along the east coast, can negatively affect golf rounds played not only during the storms but also for a significant period of time afterwards as storm damaged golf courses are repaired and golfers focus on repairing the damage to their homes, businesses and communities. Consequently, sustained adverse weather conditions, especially during the warm weather months, could materially affect the Company’s sales.

New golf club and golf ball products generally seek to satisfy the standards established by the USGA and R&A because these standards are generally followed by golfers within their respective jurisdictions. The USGA rules are generally followed in the United States, Canada and Mexico, and the R&A rules are generally followed in most other countries throughout the world.

The Rules of Golf as published by the R&A and the USGA are virtually the same except with respect to the regulation of “driving clubs.” The R&A rules currently permit driver clubheads with greater flexibility (as measured by a specific test) than are permitted under the USGA rules. As a result, in jurisdictions where the R&A rules are followed, the Company (like many of its competitors) has marketed and sold drivers that conform to the R&A rules but not the USGA rules (the “Plus Drivers”). In those jurisdictions where the USGA rules are followed the Company markets and sells its standard drivers that conform to both the R&A and the USGA rules. All of the Company’s other products are believed to conform to both the USGA and R&A rules.

Effective January 1, 2008, the more flexible clubheads such as those used for the Plus Drivers will not be conforming under the generally applicable Rules of Golf as published by the R&A. It is not clear what effect the change in rules will have upon demand for Plus Drivers in R&A jurisdictions as 2008 approaches or subsequent to the implementation of the new restrictions. It is possible that some jurisdictions and/or golfers will choose not to follow the R&A’s changes and will instead continue to use Plus drivers. This uncertainty adversely affects the Company’s research and development and manufacturing operations which must plan and commit resources years in advance of a new product release. If the Company does not accurately anticipate consumer reaction to the new rule changes, the Company’s sales in such jurisdictions could be adversely affected and the Company could be required to expend significant resources to change its product offerings at such time. The Company also believes that the general confusion created by the ruling bodies of golf as to what is a conforming or non-conforming driver and the limits imposed on new driver technology have hurt sales of drivers generally.

There is no assurance that the Company’s future products will satisfy USGA and/or R&A standards, or that existing USGA and/or R&A standards will not be altered in ways that adversely affect the sales of the

Company’s products or the Company’s brand. If a change in rules were adopted and caused one or more of the Company’s current products to be non-conforming, the Company’s sales of such products could be adversely affected. Furthermore, any such new rules could restrict the Company’s ability to develop new products.

The Company establishes relationships with professional golfers in order to evaluate and promote Callaway Golf, Odyssey, Top-Flite and Ben Hogan branded products. The Company has entered into endorsement arrangements with members of the various professional tours, including the Champions Tour, the PGA Tour, the LPGA Tour, the PGA European Tour, the Japan Golf Tour and the Nationwide Tour. While most professional golfers fulfill their contractual obligations, some have been known to stop using a sponsor’s products despite contractual commitments. If certain of the Company’s professional endorsers were to stop using the Company’s products contrary to their endorsement agreements, the Company’s business could be adversely affected in a material way by the negative publicity or lack of endorsement.

The Company believes that professional usage of its golf clubs and golf balls contributes to retail sales. The Company therefore spends a significant amount of money to secure professional usage of its products. Many other companies, however, also aggressively seek the patronage of these professionals and offer many inducements, including significant cash rewards and specially designed products. There is a great deal of competition to secure the representation of tour professionals. As a result, it is becoming increasingly difficult and more expensive to attract and retain such tour professionals. The inducements offered by other companies could result in a decrease in usage of the Company’s products by professional golfers or limit the Company’s ability to attract other tour professionals. A decline in the level of professional usage of the Company’s products could have a material adverse effect on the Company’s sales and business.

The golf club industry, in general, has been characterized by widespread imitation of popular club designs. The Company has an active program of enforcing its proprietary rights against companies and individuals who market or manufacture counterfeits and “knock off” products, and asserts its rights against infringers of its copyrights, patents, trademarks, and trade dress. However, there is no assurance that these efforts will reduce the level of acceptance obtained by these infringers. Additionally, there can be no assurance that other golf club manufacturers will not be able to produce successful golf clubs which imitate the Company’s designs without infringing any of the Company’s copyrights, patents, trademarks, or trade dress.

An increasing number of the Company’s competitors have, like the Company itself, sought to obtain patent, trademark, copyright or other protection of their proprietary rights and designs for golf clubs and golf balls. As the Company develops new products, it attempts to avoid infringing the valid patents and other intellectual property rights of others. Before introducing new products, the Company’s legal staff evaluates the patents and other intellectual property rights of others to determine if changes are required to avoid infringing any valid intellectual property rights that could be asserted against the Company’s new product offerings. From time to time, others have contacted or may contact the Company to claim that they have proprietary rights that have been infringed by the Company and/or its products. The Company evaluates any such claims and, where appropriate, has obtained or sought to obtain licenses or other business arrangements. To date, there have been no interruptions in the Company’s business as a result of any claims of infringement. No assurance can be given, however, that the Company will not be adversely affected in the future by the assertion of intellectual property rights belonging to others. This effect could include alteration or withdrawal of existing products and delayed introduction of new products.

Various patents have been issued to the Company’s competitors in the golf ball industry. As the Company develops its golf ball products, it attempts to avoid infringing valid patents or other intellectual property rights. Despite these attempts, it cannot be guaranteed that competitors will not assert and/or a court will not find that the Company’s golf balls infringe certain patent or other rights of competitors. If the Company’s golf balls are found to infringe on protected technology, there is no assurance that the Company would be able to obtain

The Company has procedures to maintain the secrecy of its confidential business information. These procedures include criteria for dissemination of information and written confidentiality agreements with employees and suppliers. Suppliers, when engaged in joint research projects, are required to enter into additional confidentiality agreements. While these efforts are taken seriously, there can be no assurance that these measures will prove adequate in all instances to protect the Company’s confidential information.

The Company’s Code of Conduct prohibits misappropriation of trade secrets and confidential information of third parties. The Code of Conduct is contained in the Company’s Employee Handbook and available to all employees on the Company’s website. Employees also sign an Employee Invention and Confidentiality Agreement prohibiting disclosure of trade secrets and confidential information from third parties. Periodic training is provided to employees on this topic as well. Despite taking these steps, as well as others, the Company cannot guarantee that these measures will be adequate in all instances to prevent misappropriation of trade secrets from third parties or the accusation by a third party that such misappropriation has taken place.

The Company licenses its trademarks to third party licensees who produce, market and sell their products bearing the Company’s trademarks. The Company chooses its licensees carefully and imposes upon such licensees various restrictions on the products, and on the manner, on which such trademarks may be used. Despite these restrictions, or if a licensee fails to adhere to these restrictions, the Company’s brand could be damaged by the use or misuse of the Company’s trademarks in connection with its licensees’ products.

Golf Clubs. The Company supports all of its golf clubs with a limited two year written warranty. Since the Company does not rely upon traditional designs in the development of its golf clubs, its products may be more likely to develop unanticipated problems than those of many of its competitors that use traditional designs. For example, clubs have been returned with cracked clubheads, broken graphite shafts and loose medallions. While any breakage or warranty problems are deemed significant by the Company, the incidence of defective clubs returned to date has not been material in relation to the volume of clubs that have been sold.

The Company monitors the level and nature of any golf club breakage and, where appropriate, seeks to incorporate design and production changes to assure its customers of the highest quality available in the market. Significant increases in the incidence of breakage or other product problems may adversely affect the Company’s sales and image with golfers. The Company believes that it has adequate reserves for warranty claims. If the Company were to experience an unusually high incidence of breakage or other warranty problems in excess of these reserves, the Company’s financial results would be adversely affected. See above, “Critical Accounting Policies and Estimates — Warranty.”

Golf Balls. The Company has not experienced significant returns of defective golf balls, and in light of the quality control procedures implemented in the production of its golf balls, the Company does not expect a significant amount of defective ball returns. However, if future returns of defective golf balls were significant, it could have a material adverse effect upon the Company’s golf ball business.

Some quantities of the Company’s products find their way to unapproved outlets or distribution channels. This “gray market” for the Company’s products can undermine authorized retailers and foreign wholesale distributors who promote and support the Company’s products, and can injure the Company’s image in the minds of its customers and consumers. On the other hand, stopping such commerce could result in a potential decrease in sales to those customers who are selling Callaway Golf products to unauthorized distributors and/or an increase in sales returns over historical levels. While the Company has taken some lawful steps to

The Company’s management believes that controlling the distribution of its products in certain major markets in the world has been and will be an element in the future growth and success of the Company. The Company sells and distributes its products directly (as opposed to through third party distributors) in many key international markets in Europe, Asia, North America and elsewhere around the world. These activities have resulted and will continue to result in investments in inventory, accounts receivable, employees, corporate infrastructure and facilities. In addition, there are a limited number of suppliers of golf club components in the United States and the Company has increasingly become more reliant on suppliers and vendors located outside of the United States. The operation of foreign distribution in the Company’s international markets, as well as the management of relationships with international suppliers and vendors, will continue to require the dedication of management and other Company resources.

As a result of this international business, the Company is exposed to increased risks inherent in conducting business outside of the United States. In addition to foreign currency risks, these risks include (i) increased difficulty in protecting the Company’s intellectual property rights and trade secrets, (ii) unexpected government action or changes in legal or regulatory requirements, (iii) social, economic or political instability, (iv) the effects of any anti-American sentiments on the Company’s brands or sales of the Company’s products, (v) increased difficulty in controlling and monitoring foreign operations from the United States, including increased difficulty in identifying and recruiting qualified personnel for its foreign operations, and (vi) increased exposure to interruptions in air carrier or shipping services which interruptions could significantly adversely affect the Company’s ability to obtain timely delivery of components from international suppliers or to timely deliver its products to international customers. Although the Company believes the benefits of conducting business internationally outweigh these risks, any significant adverse change in circumstances or conditions could have a significant adverse effect upon the Company’s operations and therefore financial performance and condition.

The Company primarily sells its products to golf equipment retailers directly and through wholly-owned domestic and foreign subsidiaries, and to foreign distributors. The Company performs ongoing credit evaluations of its customers’ financial condition and generally requires no collateral from these customers. Historically, the Company’s bad debt expense has been low. However, a downturn in the retail golf equipment market could result in increased delinquent or uncollectible accounts for some of the Company’s significant customers. In addition, as the Company integrates its foreign distribution its exposure to credit risks increases as it no longer sells to a few wholesalers but rather directly to many retailers. A failure by the Company’s customers to pay a significant portion of outstanding account receivable balances would adversely impact the Company’s performance and financial condition.

All of the Company’s major operations, including manufacturing, distribution, sales and accounting, are dependent upon the Company’s information computer systems. The Callaway Golf business information systems and the acquired Top-Flite information systems are different and the Company is therefore currently operating multiple platforms. The Company is in the process of evaluating whether to integrate the two systems and the best manner of doing so. Any significant disruption in the operation of such systems, as a result of an internal system malfunction, infection from an external computer virus, or complications in connection with any attempted integration of the two systems, or otherwise, would have a significant adverse effect upon the Company’s ability to operate its business. Although the Company has taken steps to mitigate the effect of any such disruptions, there is no assurance that such steps would be adequate in a particular situation. Consequently, a significant or extended disruption in the operation of the Company’s information

The Company currently and historically has accounted for its stock based compensation under Accounting Principles Board Opinion No. 25 (“APB No. 25”). Under APB No. 25, the Company is not required to record compensation expense for stock option grants to employees when the exercise price of the award is equal to the fair market value of the common stock on the date of grant. The Financial Accounting Standards Board has recently proposed rules which, if adopted as anticipated, would require the Company to begin recording compensation expense for such stock option awards based upon the fair value of such awards for all periods beginning after June 15, 2005. As a result, beginning in 2005, it is anticipated that the Company will be required to record compensation expense for any such awards granted in 2005 as well as awards granted prior to 2005 which vest on July 1, 2005 or thereafter. Such noncash compensation expense is anticipated to have a significant effect upon the Company’s reported earnings.

Although the Company has historically provided in the notes to its financial statements pro forma earnings information showing what the Company’s results would have been had the Company been recording compensation expense for such awards, the amount of such expense was not reflected in its financial results. Consequently, if the Company begins recording such compensation expense in 2005, the period over period comparisons will be significantly affected by the inclusion of such expense in 2005 and the absence of such expense from 2004 and prior periods. If investors do not appropriately consider these changes in accounting rules, the price at which the Company’s stock is traded could be significantly adversely affected.

The Company’s stock is traded publicly, principally on the New York Stock Exchange. As a result, at any given time, there are usually various securities analysts which follow the Company and issue reports on the Company. These reports include information about the Company’s historical financial results as well as the analysts’ estimates of the Company’s future performance. The analysts’ estimates are based upon their own opinions and are often different from the Company’s own estimates or expectations. The Company has a policy against 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. In addition to analyst reports, the media also reports its opinion on the Company’s results. These media reports are often written quickly so as to be the first to the news wire and in an attempt to garner attention often lead with headlines that are not representative of the substance of the article. Furthermore, these media reports, which are often written by writers who are not financial experts, reflect only the writers’ views of the Company’s results. Investors should not assume that the Company agrees with such media reports or the manner in which the Company’s results are presented or characterized in such reports.

The price at which the Company’s stock is traded on the securities exchanges is based upon many factors. In the short-term, the price at which the Company’s stock is traded can be significantly affected, positively or negatively, by analysts’ reports and media reports, regardless of the accuracy of such reports. Over the long-term, the price at which the Company’s stock is traded should tend to reflect the Company’s performance irrespective of such reports.

The Company from time to time provides investors with estimates of anticipated revenues and earnings per share on an annual basis and reports on how the Company is progressing toward the achievement of those annual targets. The Company cannot predict its results with certainty. The Company’s estimates are based upon the information available and management’s expectations at the time such estimates are made and actual results could and often do differ materially. See “Important Notice to Investors” on the inside cover of this report.

The Company uses derivative financial instruments for hedging purposes to limit its exposure to changes in foreign exchange rates. Transactions involving these financial instruments are with credit-worthy firms. The use of these instruments exposes the Company to market and credit risk which may at times be concentrated with certain counterparties, although counterparty nonperformance is not anticipated. The Company also utilized a derivative commodity instrument, the Enron Contract, to manage electricity costs in the volatile California energy market during the period of June 2001 through November 2001. Pursuant to its terms, the Enron Contract was terminated. The Company is also exposed to interest rate risk from its credit facility.

In the normal course of business, the Company is exposed to foreign currency exchange rate risks that could impact the Company’s results of operations. The Company’s risk management strategy includes the use of derivative financial instruments, including forward contracts and purchased options, to hedge certain of these exposures. The Company’s objective is to offset gains and losses resulting from these exposures with gains and losses on the derivative contracts used to hedge them, thereby reducing volatility of earnings. The Company does not enter into any trading or speculative positions with regard to foreign currency related derivative instruments.

The Company is exposed to foreign currency exchange rate risk inherent primarily in its sales commitments, anticipated sales and assets and liabilities denominated in currencies other than the U.S. dollar. The Company transacts business in approximately 12 currencies worldwide, of which the most significant to its operations are the European currencies, Japanese Yen, Korean Won, Canadian Dollar, and Australian Dollar. For most currencies, the Company is a net receiver of foreign currencies and, therefore, benefits from a weaker U.S. dollar and is adversely affected by a stronger U.S. dollar relative to those foreign currencies in which the Company transacts significant amounts of business.

At September 30, 2004 and 2003, the notional amounts of the Company’s foreign exchange contracts were approximately $33.5 million and $87.7 million, respectively. The Company estimates the fair values of derivatives based on quoted market prices or pricing models using current market rates, and records all derivatives on the balance sheet at fair value. At September 30, 2004, the fair value of foreign currency-related derivatives were recorded as current assets of $0.2 million and current liabilities of $0.7 million.

There were no notional amounts of the Company’s foreign exchange contracts designated as cash flow hedges at September 30, 2004. At September 30, 2003, the notional amounts of the Company’s foreign exchange contracts designated as cash flow hedges were approximately $42.9 million. For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is initially recorded in accumulated other comprehensive income (“OCI”) as a separate component of shareholders’ equity and subsequently reclassified into earnings in the period during which the

During the three and nine months ended September 30, 2004, no gains or losses were reclassified into earnings as a result of the discontinuance of cash flow hedges.

As of September 30, 2004, $0.1 million of deferred net losses related to derivative instruments designated as cash flow hedges were included in OCI. These derivative instruments hedge transactions that are expected to occur within the next twelve months. As the hedged transactions are completed, the related deferred net gain or loss is reclassified from OCI into earnings. The Company does not expect that such reclassifications will have a material effect on the Company’s earnings, as any gain or loss on the derivative instruments generally would be offset by the opposite effect on the related underlying transactions.

The ineffective portion of the gain or loss for derivative instruments that are designated and qualify as cash flow hedges is immediately reported as a component of other income (expense), net. For foreign currency contracts designated as cash flow hedges, hedge effectiveness is measured using the spot rate. Changes in the spot-forward differential are excluded from the test of hedging effectiveness and are recorded currently in earnings as a component of other income (expense), net. During the three months ended September 30, 2004 and 2003, the Company recorded net losses of $0 and less than $0.1 million, respectively, as a result of changes in the spot-forward differential. During the nine months ended September 30, 2004 and 2003, the Company recorded net losses of $0.1 million and less than $0.1 million, respectively, as a result of changes in the spot-forward differential. Assessments of hedge effectiveness are performed using the dollar offset method and applying a hedge effectiveness ratio between 80% and 125%. Given that both the hedged item and the hedging instrument are evaluated using the same spot rate, the Company anticipates the hedges to be highly effective. The effectiveness of each derivative is assessed quarterly.

At September 30, 2004 and 2003, the notional amounts of the Company’s foreign exchange contracts used to hedge outstanding balance sheet exposures were approximately $33.5 million and $87.7 million, respectively. The gains and losses on foreign currency contracts used to hedge balance sheet exposures are recognized as a component of other income (expense), net in the same period as the remeasurement gain and loss of the related foreign currency denominated assets and liabilities and thus offset these gains and losses. During the three months ended September 30, 2004 and 2003, the Company recorded net losses of $0.9 million and net losses of $0.7 million, respectively, due to net realized and unrealized gains and losses on contracts used to hedge balance sheet exposures. During the nine months ended September 30, 2004 and 2003, the Company recorded net losses of $0.3 million and net losses of $5.0 million, respectively, due to net realized and unrealized gains and losses on contracts used to hedge balance sheet exposures.

Sensitivity analysis is the measurement of potential loss in future earnings of market sensitive instruments resulting from one or more selected hypothetical changes in interest rates or foreign currency values. The Company used a sensitivity analysis model to quantify the estimated potential effect of unfavorable movements of 10% in foreign currencies to which the Company was exposed at September 30, 2004 through its derivative financial instruments.

The sensitivity analysis model is a risk analysis tool and does not purport to represent actual losses in earnings that will be incurred by the Company, nor does it consider the potential effect of favorable changes in market rates. It also does not represent the maximum possible loss that may occur. Actual future gains and

The estimated maximum one-day loss from the Company’s foreign-currency derivative financial instruments, calculated using the sensitivity analysis model described above, is $3.6 million at September 30, 2004. The portion of the estimated loss associated with the foreign exchange contracts that offset the remeasurement gain and loss of the related foreign currency denominated assets and liabilities is $3.6 million at September 30, 2004 and would impact earnings. There would be no impact to OCI. The Company believes that such a hypothetical loss from its derivatives would be offset by increases in the value of the underlying transactions being hedged.

During the second quarter of 2001, the Company entered into the Enron Contract to manage electricity costs in the volatile California energy market. This derivative did not qualify for hedge accounting treatment under SFAS No. 133. Therefore, the Company recognized the changes in the estimated fair value of the contract based on current market rates as unrealized energy derivative losses. During the fourth quarter of 2001, the Company notified the energy supplier that, among other things, the energy supplier was in default of the energy supply contract and that based upon such default, and for other reasons, the Company was terminating the energy supply contract. As a result, the Company adjusted the estimated value of this contract through the date of termination. Because the contract is terminated and neither party to the contract is performing pursuant to the terms of the contract, the terminated contract ceased to represent a derivative instrument in accordance with SFAS No. 133. The Company, therefore, no longer records future valuation adjustments for changes in electricity rates. The Company continues to reflect the derivative valuation account on its balance sheet, subject to periodic review, in accordance with SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” See above “Supply of Electricity and Energy Contracts.”

Additionally, the Company is exposed to interest rate risk from its new credit facility (see Note 7 to the Company’s Consolidated Condensed Financial Statements). The credit facility is indexed to, at the Company’s election, based upon the Company’s consolidated leverage ratio and trailing four quarters EBITDA (each as defined in the new credit facility), of (i) the higher of (a) the Federal Funds Rate plus 50.0 basis points or (b) Bank of America’s prime rate, and in either case plus a margin of 00.0 to 75.0 basis points or (ii) the Eurodollar Rate (as defined in the new credit facility) plus a margin of 75.0 to 200.0 basis points.

Note 7 to the Company’s Consolidated Condensed Financial Statements outlines the principal amounts, if any, and other terms required to evaluate the expected cash flows and sensitivity to interest rate changes.

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in the Company’s periodic filings with the Securities and Exchange Commission. During the third quarter of 2004, there were no changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

As a result of Section 404 of the Sarbanes-Oxley Act of 2002 and the rules issued thereunder (collectively, the “Section 404 requirements”), the Company will be required to include in its Annual Report on Form 10-K for the year ending December 31, 2004, a report on management’s assessment of the effectiveness of the Company’s internal controls over financial reporting. The Company’s independent auditor will also be required to attest to and report on management’s assessment. The Company has maintained an internal audit function since 1994 and regularly tests and evaluates its internal controls, and therefore believes that it will be able to complete the assessment required by Section 404. There is no assurance, however, that future changes to the Section 404 requirements, changes in the business operations of the Company or other factors will not adversely affect the Company’s ability to complete the assessment by the date stipulated.

On October 3, 2001, the Company filed suit in the United States District Court for the District of Delaware, Civil Action No. 01-669, against Dunlop Slazenger Group Americas, Inc., d/b/a Maxfli (“Maxfli”), for infringement of a golf ball aerodynamics patent owned by the Company, U.S. Patent No. 6,213,898 (the “Aerodynamics Patent”). The Company later amended its complaint to add a claim that Maxfli engaged in false advertising by claiming that its A10 golf balls were the “longest ball on tour.” Maxfli answered the complaint denying patent infringement and false advertising, and also filed a counterclaim asserting that former Maxfli employees hired by the Company had disclosed confidential Maxfli trade secrets to the Company, and that the Company had used that information to enter the golf ball business. In the counterclaim, Maxfli sought compensatory damages of $30.0 million; punitive damages equal to two times the compensatory damages; prejudgment interest; attorneys’ fees; a declaratory judgment; and injunctive relief. On November 12, 2003, pursuant to an agreement between the Company and Maxfli, the court dismissed the Company’s claim for infringement of the Aerodynamics Patent. On May 13, 2004, the Court granted the Company’s motion for summary judgment, eliminating a portion of Maxfli’s counterclaim and reducing Maxfli’s compensatory damages claim from approximately $30.0 million to $18.5 million. The case was tried to a jury beginning on August 2, 2004. On August 12, 2004, the jury returned a verdict of $2.2 million in favor of the Company based upon its finding that Maxfli willfully engaged in false advertising. The jury also rejected Maxfli’s counterclaim that the Company used any Maxfli trade secrets. Maxfli filed post-trial motions seeking to set aside the verdict and/or obtain a new trial. In post-trial motions Callaway Golf is seeking attorneys’ fees and prejudgment interest. It is expected that if Maxfli is unsuccessful, it will appeal the verdict. If Maxfli is successful with its post-trial motions, or an appeal of the verdict, and Maxfli’s counterclaims are ultimately resolved in Maxfli’s favor, such matters could have a significant adverse effect upon the Company’s results of operations, cash flows and financial position.

On December 2, 2002, Callaway Golf Company was served with a complaint filed in the Circuit Court of the 19th Judicial District in and for Martin County, Florida, Case No. 935CA, by the Perfect Putter Co. and its principals. Plaintiffs sued Callaway Golf Company, Callaway Golf Sales Company and a Callaway Golf Sales Company sales representative. Plaintiffs alleged that the Company misappropriated certain alleged trade secrets and proprietary information of the Perfect Putter Co. and incorporated those purported trade secrets in the Company’s Odyssey White Hot 2-Ball Putter. Plaintiffs also allege that the Company made false statements and acted inappropriately during discussions with plaintiffs. Plaintiffs are seeking compensatory damages, exemplary damages, attorneys’ fees and costs, pre- and post-judgment interest and injunctive relief. On December 20, 2002, the Company removed the case to the United States District Court for the Southern District of Florida, Case No. 02-14342. On April 29, 2003, the District Court denied plaintiffs’ motion to remand the case to state court. Plaintiffs are seeking compensatory damages ranging from $11.5 million for alleged breach of contract to $206 million for alleged unjust enrichment, plus punitive damages. The trial of the action is scheduled to commence in September 2005. An unfavorable resolution of plaintiffs’ claims could have a material adverse effect upon the Company’s results of operations, cash flows and financial position.

There were no repurchases of equity securities as reported on a settlement date basis during the quarter ended September 30, 2004.

On November 5, 2004, the Company amended and restated its line of credit with Bank of America, N.A. and certain other lenders to provide for a new five year revolving line of credit. The new credit facility provides for revolving loans of up to $300 million, of which $250 million consisted of commitments available at the closing and the balance of which are available to the Company upon the satisfaction of certain conditions. Actual borrowing availability under the new credit facility is limited effectively by the financial covenants set forth in the new credit facility. As of the date of this report, the maximum amount that could be borrowed under the new credit facility was approximately $134 million. As of the date of this report, no borrowings were outstanding under the new credit facility and the Company was in compliance with the covenants and other terms thereof.

In connection with the new credit facility, the Company is required to pay certain fees, including an unused commitment fee of between 17.5 and 35.0 basis points per annum of the unused commitment amount, with the exact amount determined based upon the Company’s consolidated leverage ratio and trailing four quarters EBITDA (each as defined in the new credit facility). Outstanding borrowings under the new credit facility accrue interest at the Company’s election, based upon the Company’s consolidated leverage ratio and trailing four quarters EBITDA, of (i) the higher of (a) the Federal Funds Rate plus 50.0 basis points or (b) Bank of America’s prime rate, and in either case plus a margin of 00.0 to 75.0 basis points or (ii) the Eurodollar Rate (as defined in the new credit facility) plus a margin of 75.0 to 200.0 basis points. The Company has agreed that repayment of amounts under the new credit facility will be guaranteed by certain of the Company’s domestic subsidiaries and will be secured by substantially all of the assets of the Company and such guarantor subsidiaries. The collateral (other than 65% of the stock of the Company’s foreign subsidiaries) will be released upon the satisfaction of certain financial conditions.

The above summary of the provisions of the new credit facility is qualified in its entirety by the terms of the new credit facility, as set forth in Exhibit 10.48 to this Form 10-Q.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	By:	/s/ BRADLEY J. HOLIDAY



	Bradley J. Holiday
	Senior Executive Vice President and
	Chief Financial Officer


Delaware		95-3797580
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)


PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)	1
	Consolidated Condensed Balance Sheets at September 30, 2004 and December 31, 2003	1
	Consolidated Condensed Statements of Operations for the three and nine months ended September 30, 2004 and 2003	2
	Consolidated Condensed Statements of Cash Flows for the nine months ended September 30, 2004 and 2003	3
	Consolidated Condensed Statement of Shareholders’ Equity for the nine months ended September 30, 2004	4
	Notes to Consolidated Condensed Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	44
Item 4.	Controls and Procedures	46
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	47
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	49
Item 3.	Defaults Upon Senior Securities	49
Item 4.	Submission of Matters to a Vote of Security Holders	49
Item 5.	Other Information	49
Item 6.	Exhibits	50
EXHIBIT 10.47
EXHBIIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1


				September 30,			December 31,
				2004			2003

ASSETS
Current assets:
	Cash and cash equivalents			$	67,518		$	47,340
	Accounts receivable, net				114,857			100,664
	Inventories, net				161,462			185,389
	Deferred income taxes				38,643			36,707
	Income taxes receivable				26,982			—
	Other current assets				13,855			13,362

		Total current assets			423,317			383,462
Property, plant and equipment, net					139,707			164,763
Intangible assets, net					147,936			149,635
Goodwill					29,168			20,216
Deferred income taxes					—			12,289
Other assets					15,193			18,201

				$	755,321		$	748,566


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
	Accounts payable and accrued expenses			$	75,528		$	79,787
	Accrued employee compensation and benefits				25,990			25,544
	Accrued warranty expense				12,577			12,627
	Capital leases, current portion				53			240
	Income taxes payable				—			11,962

			Total current liabilities		114,148			130,160
Long-term liabilities:
	Deferred compensation				9,055			8,947
	Energy derivative valuation account				19,922			19,922
	Deferred income taxes				553			—
	Capital leases, long-term portion				28			154
Commitments and contingencies (Note 10)
Shareholders’ equity:
	Preferred Stock, $.01 par value, 3,000,000 shares authorized, none issued and outstanding at September 30, 2004 and December 31, 2003				—			—
	Common Stock, $.01 par value, 240,000,000 shares authorized, 83,781,944 and 83,710,094 issued at September 30, 2004 and December 31, 2003, respectively				838			837
	Paid-in capital				352,918			400,939
	Unearned compensation				(702	)		—
	Retained earnings				470,574			466,441
	Accumulated other comprehensive income				6,655			2,890
	Less: Grantor Stock Trust held at market value, 7,311,678 shares and 8,702,577 shares at September 30, 2004 and December 31, 2003, respectively				(77,284	)		(146,638	)

					752,999			724,469
	Less: Common Stock held in treasury, at cost, 8,497,667 and 8,144,667 shares at September 30, 2004 and December 31, 2003, respectively				(141,384	)		(135,086	)

			Total shareholders’ equity		611,615			589,383

				$	755,321		$	748,566



			Three Months Ended										Nine Months Ended
			September 30,										September 30,


			2004					2003					2004					2003


Net sales			$	128,457		100	%	$	153,634		100	%	$	790,151		100	%	$	667,430	100	%
Cost of sales				102,386		80	%		83,414		54	%		470,053		59	%		332,878	50	%

	Gross profit			26,071		20	%		70,220		46	%		320,098		41	%		334,552	50	%
Operating expenses:
	Selling expenses			58,300		45	%		47,462		31	%		203,991		26	%		149,527	22	%
	General and administrative expenses			23,219		18	%		14,684		10	%		67,914		9	%		43,154	6	%
	Research and development expenses			7,855		6	%		7,734		5	%		23,523		3	%		20,648	3	%

		Total operating expenses		89,374		70	%		69,880		45	%		295,428		37	%		213,329	32	%

Income (loss) from operations				(63,303	)	(49)	%		340		0	%		24,670		3	%		121,223	18	%
Other income (expense), net				1,091					1,056					(230	)				1,345

Income (loss) before income taxes				(62,212	)	(48)	%		1,396		1	%		24,440		3	%		122,568	18	%
Provision for (benefit from) income taxes				(26,317	)				(938	)				6,075					43,613

Net income (loss)			$	(35,895	)	(28)	%	$	2,334		2	%	$	18,365		2	%	$	78,955	12	%

Earnings (loss) per common share:
	Basic		$	(0.53	)			$	0.04				$	0.27				$	1.20
	Diluted		$	(0.53	)			$	0.03				$	0.27				$	1.19
Weighted-average shares outstanding:
	Basic			67,847					66,261					67,641					65,936
	Diluted			67,847					66,808					68,235					66,295
Dividends declared per share			$	0.07				$	0.07				$	0.21				$	0.21



				Nine Months Ended
				September 30,

				2004			2003

Cash flows from operating activities:
	Net income			$	18,365		$	78,955
	Adjustments to reconcile net income to net cash provided by operating activities:
		Depreciation and amortization			39,027			30,447
		Loss on disposal of long-lived assets			4,270			1,580
		Tax benefit (reversal of benefit) from exercise of stock options			1,882			(1,623	)
		Non-cash compensation			101			15
		Net non-cash foreign currency hedging losses			1,723			2,628
		Net losses from sale of marketable securities			—			98
		Deferred income taxes			12,254			422
		Changes in assets and liabilities, net of effects of acquisition:
			Accounts receivable, net		(13,710	)		(40,009	)
			Inventories, net		26,111			39,767
			Other assets		4,238			(1,290	)
			Accounts payable and accrued expenses		(9,286	)		1,272
			Accrued employee compensation and benefits		334			264
			Accrued warranty expense		(51	)		151
			Income taxes payable (receivable)		(39,234	)		26,598
			Deferred compensation		108			828

	Net cash provided by operating activities				46,132			140,103

Cash flows from investing activities:
	Business acquisitions, net of cash acquired				(9,204	)		(165,147	)
	Capital expenditures				(16,065	)		(4,826	)
	Proceeds from sale of capital assets				415			114
	Proceeds from sale of marketable securities				—			24

	Net cash used in investing activities				(24,854	)		(169,835	)

Cash flows from financing activities:
	Issuance of Common Stock				18,649			12,875
	Acquisition of Treasury Stock				(6,298	)		(3,220	)
	Dividends paid, net				(14,232	)		(13,863	)
	Payments on financing arrangements				—			(2,590	)

	Net cash used in financing activities				(1,881	)		(6,798	)

Effect of exchange rate changes on cash and cash equivalents					781			913

Net increase (decrease) in cash and cash equivalents					20,178			(35,617	)
Cash and cash equivalents at beginning of period					47,340			108,452

Cash and cash equivalents at end of period				$	67,518		$	72,835

Non-cash financing activities:
	Issuance of restricted stock			$	800		$	—
	Liabilities assumed in connection with acquisition			$	4,380		$	20,588


														Accumulated
	Common Stock													Other						Treasury Stock
					Paid-in			Unearned			Retained			Comprehensive
	Shares		Amount		Capital			Compensation			Earnings			Income			GST			Shares			Amount			Total

Balance, December 31, 2003		83,710	$	837	$	400,939		$	—		$	466,441		$	2,890		$	(146,638	)		(8,145	)	$	(135,086	)	$	589,383

Exercise of stock options		19		—		(3,713	)		—			—			—			17,705			—			—			13,992
Tax benefit from exercise of stock options		—		—		1,882			—			—			—			—			—			—			1,882
Issuance of restricted common stock		53		1		800			(801	)		—			—			—			—			—			—
Acquisition of treasury stock		—		—		—			—			—			—			—			(353	)		(6,298	)		(6,298	)
Compensatory stock and stock options		—		—		2			99			—			—			—			—			—			101
Employee stock purchase plan		—		—		(1,302	)		—			—			—			5,959			—			—			4,657
Cash dividends declared		—		—		—			—			(14,232	)		—			—			—			—			(14,232	)
Adjustment of Grantor Stock Trust shares to market value		—		—		(45,690	)		—			—			—			45,690			—			—			—
Equity adjustment from foreign currency translation		—		—		—			—			—			(16	)		—			—			—			(16	)
Unrealized gain on cash flow hedges, net of tax		—		—		—			—			—			3,781			—			—			—			3,781
Net income		—		—		—			—			18,365			—			—			—			—			18,365

Balance, September 30, 2004		83,782	$	838	$	352,918		$	(702	)	$	470,574		$	6,655		$	(77,284	)		(8,498	)	$	(141,384	)	$	611,615


Assets:
	Cash		$	5,971
	Accounts receivable			85
	Inventory			1,962
	Other current assets			312
	Property, plant and equipment			258
	Internally developed software			1,200
	Customer lists			904
	Goodwill			8,863
Liabilities:
	Current liabilities			(4,373	)
	Long-term liabilities			(7	)

		Total net assets acquired	$	15,175


Assets Acquired:
	Accounts receivable		$	45,360
	Inventory			32,746
	Other assets			1,147
	Property, plant and equipment			55,775
	Intangible assets (Note 6)			47,932
Liabilities Assumed:
	Current liabilities			(17,398	)
	Long-term liabilities			(5,086	)

		Total net assets acquired	$	160,476



				September 30, 2004						December 31, 2003
		Useful
		Life				Accumulated		Net Book				Accumulated		Net Book
		(Years)		Gross		Amortization		Value		Gross		Amortization		Value

Non-amortizing:
	Trade name, trademark and trade dress⁽¹⁾⁽²⁾			$	121,794	$	—	$	121,794	$	120,605	$	—	$	120,605
Amortizing:
	Patents⁽³⁾		3-16		33,165		8,968		24,197		32,277		7,251		25,026
	Other⁽²⁾⁽⁴⁾		1-9		3,080		1,135		1,945		4,386		382		4,004

Total intangible assets				$	158,039	$	10,103	$	147,936	$	157,268	$	7,633	$	149,635


Remainder of 2004	$	693
2005		2,754
2006		2,703
2007		2,700
2008		2,659
2009		2,456
Thereafter		12,177

	$	26,142



		Three Months
		Ended						Nine Months Ended
		September 30,						September 30,

		2004			2003			2004			2003

Beginning OCI balance related to cash flow hedges		$	(258	)	$	(561	)	$	(2,518	)	$	(1,362	)
	Add: Net gain/(loss) initially recorded in OCI		—			(1,076	)		810			(2,420	)
	Deduct: Net loss reclassified from OCI into earnings		(170	)		(475	)		(1,620	)		(2,620	)

Ending OCI balance related to cash flow hedges		$	(88	)	$	(1,162	)	$	(88	)	$	(1,162	)


Item 2.	*Management’s Discussion and Analysis of Financial Condition and Results of Operations*



		For the Three
		Months Ended
		September 30,				Growth/(Decline)

		2004		2003		Dollars			Percent

Net sales:
	Woods	$	14.3	$	44.0	$	(29.7	)		(67)	%
	Irons^(*)		36.3		56.1		(19.8	)		(35)	%
	Putters		15.6		27.0		(11.4	)		(42)	%
	Golf balls		41.2		14.1		27.1			191	%
	Accessories and other^(*)		21.1		12.4		8.7			70	%

		$	128.5	$	153.6	$	(25.1	)		(16)	%



	Three Months Ended September 30,


	2004												*2003^()**

	Callaway			Top-Flite			Integration
	Golf			Golf			Charges			Total			Total

Net sales	$	89,788		$	38,669		$	—		$	128,457		$	153,634
Gross profit (loss)		22,107			8,784			(4,820	)		26,071			70,220
% of sales		25%			23%			n/a			20%			46%
Operating expenses		68,925			17,801			2,648			89,374			69,880

Income (loss) from operations		(46,818	)		(9,017	)		(7,468	)		(63,303	)		340
Other income (expense), net		1,319			(228	)		—			1,091			1,056

Income (loss) before income taxes		(45,499	)		(9,245	)		(7,468	)		(62,212	)		1,396
Income tax (benefit)		(19,650	)		(3,569	)		(3,098	)		(26,317	)		(938	)

Net income (loss)	$	(25,849	)	$	(5,676	)	$	(4,370	)	$	(35,895	)	$	2,334

Diluted earnings (loss) per share	$	(0.38	)	$	(0.08	)	$	(0.07	)	$	(0.53	)	$	0.03
Weighted-average shares outstanding		67,847			67,847			67,847			67,847			66,808



		For the Nine
		Months Ended
		September 30,				Growth (Decline)

		2004		2003		Dollars			Percent

Net sales:
	Woods	$	213.6	$	213.9	$	(0.3	)		0	%
	Irons^(*)		219.8		242.7		(22.9	)		(9)	%
	Putters		81.7		118.1		(36.4	)		(31)	%
	Golf balls		187.8		43.4		144.4			333	%
	Accessories and other^(*)		87.3		49.3		38.0			77	%

		$	790.2	$	667.4	$	122.8			18	%


Item 1.	*Financial Statements*


1.	Basis of Presentation


2.	Business Acquisitions


	*FrogTrader Stock Purchase*



	Nine Months Ended September 30,


	2004												*2003^()**

	Callaway			Top-Flite			Integration
	Golf			Golf			Charges			Total			Total

Net sales	$	614,557		$	175,594		$	—		$	790,151		$	667,430
Gross profit (loss)		278,490			55,766			(14,158	)		320,098			334,552
% of sales		45%			32%			n/a			41%			50%
Operating expenses		221,886			64,436			9,106			295,428			213,329

Income (loss) from operations		56,604			(8,670	)		(23,264	)		24,670			121,223
Other income (expense), net		(415	)		185			—			(230	)		1,345

Income (loss) before income taxes		56,189			(8,485	)		(23,264	)		24,440			122,568
Income tax provision (benefit)		18,362			(3,284	)		(9,003	)		6,075			43,613

Net income (loss)	$	37,827		$	(5,201	)	$	(14,261	)	$	18,365		$	78,955

Diluted earnings (loss) per share	$	0.55		$	(0.08	)	$	(0.20	)	$	0.27		$	1.19
Weighted-average shares outstanding		68,235			68,235			68,235			68,235			66,295



		Payments Due By Period

				Less than						More than
		Total		1 Year		1-3 Years		4-5 Years		5 Years

Long-term debt obligations			—		—		—		—		—
Operating leases⁽¹⁾			18.6		6.1		8.1		2.4		2.0
Capital leases⁽²⁾			0.1		0.1		—		—		—
Unconditional purchase obligations⁽³⁾			135.3		43.8		49.7		35.6		6.2
Deferred compensation⁽⁴⁾			9.1		1.0		1.1		0.6		6.4

	Total⁽⁵⁾	$	163.1	$	51.0	$	58.9	$	38.6	$	14.6


Item 3.	*Quantitative and Qualitative Disclosures About Market Risk*



		Three Months						Nine Months
		Ended						Ended
		September 30,						September 30,

		2004			2003			2004			2003

Beginning OCI balance related to cash flow hedges		$	(0.3	)	$	(0.6	)	$	(2.5	)	$	(1.4	)
	Add: Net gain/(loss) initially recorded in OCI		—			(1.1	)		0.8			(2.4	)
	Deduct: Net loss reclassified from OCI into earnings		(0.2	)		(0.5	)		(1.6	)		(2.6	)

Ending OCI balance related to cash flow hedges		$	(0.1	)	$	(1.2	)	$	(0.1	)	$	(1.2	)


Item 2.	*Unregistered Sales of Equity Securities and Use of Proceeds*


Item 4.	*Submission of Matters to a Vote of Security Holders*


3.1		Certificate of Incorporation, incorporated herein by this reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K, as filed with the Securities and Exchange Commission (“Commission”) on July 1, 1999 (file no. 1-10962).
3.2		Third Amended and Restated Bylaws, as amended and restated as of December 3, 2003, incorporated herein by this reference to Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, as filed with the Commission on March 15, 2004 (file no. 1-10962).
4.1		Dividend Reinvestment and Stock Purchase Plan, incorporated herein by this reference to the Prospectus in the Company’s Registration Statement on Form S-3, as filed with the Commission on March 29, 1994 (file no. 33-77024).
4.2		Rights Agreement by and between the Company and Mellon Investor Services LLC (f/k/a Chemical Mellon Shareholder Services) as Rights Agent, dated as of June 21, 1995, incorporated herein by this reference to Exhibit 4.0 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 1995, as filed with the Commission on August 12, 1995 (file no. 1-10962).
4.3		First Amendment to Rights Agreement, effective June 22, 2001, by and between the Company and Mellon Investor Services LLC, as Rights Agent, incorporated herein by this reference to Exhibit 4.3 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, as filed with the Commission on March 21, 2002 (file no. 1-10962).
10.48		Amended and Restated Credit Agreement, dated November 5, 2004, among the Company, each lender from time to time party thereto, and Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer.†
31.1		Certification of William C. Baker pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.†
31.2		Certification of Bradley J. Holiday pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.†
32.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.†


Exhibit			Description

	10	.48	Amended and Restated Credit Agreement, dated November 5, 2004, among the Company, each lender from time to time party thereto, and Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer.†
	31	.1	Certification of William C. Baker pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.†
	31	.2	Certification of Bradley J. Holiday pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.†
	32	.1	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.†