Upbound Group: Strong Growth In Acima Provides Upside Potential (NASDAQ:UPBD)

miniseriesInvestment thesis Upbound Group (NASDAQ:UPBD) continues to deliver solid results, outperforming its peers thanks to exceptional growth in its Acima business. Shares are currently trading at an attractive valuation given the anticipated growth rates, with an EV to adjusted EBITDA multiple of 6.1 and a P/E ratio of 8.2. The recent acquisition offer for Aaron’s (AAN) highlights how undervalued the sector has become. Management is returning capital to shareholders through dividends, but a major portion of its future FCF will be dedicated to debt paydown. Though the business is likely to suffer in case of further weakening in the economy, I believe the company is well positioned and the current valuation presents an attractive risk-reward to initiate a long position. Highlights from its recent earnings Strong growth in Acima Q1 earnings presentationUpbound Group’s Q1 revenue was up 7.9%, thanks to the significant growth demonstrated by Acima, which now contributed more than 53% of the total revenue. As shown above, GMV at Acima grew by almost 20% versus Q1 2023 and was considerably higher than management’s 10% to 12% growth target presented during last year’s investor day. Furthermore, the business saw an acceleration in growth in Q1 compared to the 19% year-over-year growth seen in Q4 2023. In addition to strong demand for credit from its consumers, Acima also benefited from elevated activity at its large enterprise partners, such as Wayfair (W) and Ansell (OTCPK:ANSLF). Its direct-to-consumer business, which is the Acima marketplace, saw a 51% growth in GMV. During the Q1 2024 earnings call, Upbound’s CEO Mitch Fadel noted that he continues to observe accelerating revenue growth for Acima. He further elaborated, stating: We are pleased to recently announce another exclusive relationship with a top 50 furniture retailer in the quarter which came online in late April. Overall, Acima exited the first quarter with an open lease count that was more than 24% higher versus last year as well as sequentially higher than our seasonally high fourth quarter. Stable performance at Rent-A-Center Revenue from the Rent-A-Center (RCA) segment was largely stable, with revenue up 0.2% year over year. This was an improvement compared to the 1.7% decline seen during the fourth quarter of 2023. The Lease Charge-off rate (LCO) also improved to 4.7% compared to 4.8% in the prior year period. Higher gross margins helped drive adjusted EBITDA margins to 16.6%, compared to 15.2% in the prior year period. Lower Free Cash Flow The company’s free cash flow (FCF) was significantly lower compared to the same quarter last year. Moreover, FCF guidance for the year is also expected to be much lower than in FY 2023. The reason behind it is not too concerning so investors as this is due to the increase in working capital needs to support strong GMV growth in the Acima business. This was confirmed by its CFO during the Q1 earnings call where he stated: During the first quarter, we generated $33.6 million of free cash flow, which decreased from $95.9 million in the prior year period, primarily due to Acima GMV growth. What to expect for the rest of the year Margin improvement and continued growth at Acima Tighter underwriting coupled with improvements in its risk models is expected to lead to improvements in lease charge-off rates as the year progresses, as higher loss originations in the portfolio are gradually wound down. Management’s expectations for an improvement in Acima’s LCOs was explained by its CEO when he stated: And so the second quarter loss rate will be similar to the first quarter. And then you’ll start to see a trend down. We still think for the year, we’ll end up pretty flat to where we ended in 2023, somewhere in between the 9% and 9.5% range for the year. Q1 earnings presentationThe headwinds due to high LCOs should reduce in upcoming quarters, which should lead to improving margins for the Acima business. The business is also expected to continue its strong growth, supported by recent merchant signings as it leverages its sizeable sales force. Tightening of lending standards by credit card issuers Management remarked during the Q1 earnings calls that they expect the CFPB ruling against excessive credit card late fees to have a tightening effect on credit card approval rates and approval amounts. The regulation is currently facing legal challenges, but if approved could provide a tailwind for Upbound’s business as more borrowers would seek their product as a preferred alternative. Continued deleveraging The company ended the first quarter with $1.31 billion in debt, of which around $850 million has been financed at floating rates. Its net debt to 2024 EBITDA ratio is 2.6. Quarterly net interest expenses are running at approximately $29 million, and management’s primary focus with respect to capital allocation remains the pay down of its debt. The company continues to pay a quarterly dividend of $0.37 per share, an increase of approximately 9% compared to the prior year. Thoughts on valuation Q1 earnings releaseAs shown above, management’s guidance at the midpoint for FY2024, calls for revenue and adjusted EBITDA to be $4.1 billion and $470 million respectively. This implies that shares are trading at an EV to adjusted EBITDA multiple of 6.1, based on the current share price of $31. Earnings per share is expected to be $3.78 at the midpoint, which implies that shares are currently valued at a P/E ratio of 8.2. The FCF yield remains depressed due to working capital impacts from the strong GMV growth in Acima. FCF is likely to be more than $230 million when adjusting for the effects from working capital, and is in line with historical FCF conversion rates from EBITDA. Moreover, management’s guidance during the investor day called for $650 to $850 million in accumulated FCF between 2024 and 2026. Its closest competitor, PROG Holdings (PRG), is valued at significantly higher multiples, with an EV/EBITDA of 8 and a P/E ratio of 10. This is despite PROG Holdings facing revenue declines of 2% this year, compared to the 6% growth expected for Upbound. Furthermore, its peer Aaron’s, which also faces low single-digit revenue declines this year and has a lower margin profile, has recently agreed to be acquired at an EV/EBITDA multiple of 4.4. I therefore consider shares to be attractively valued considering the company’s leading market position and growth outlook. Risks to consider Interest rates remaining higher for longer will likely lead to a deterioration in consumer credit. In this case, LCOs will remain elevated at levels above 9.6%, compared to management’s expectations of it falling closer to 9%. This will likely result in a reduction in profit margins for the company. Demand for credit from players like Upbound would likely remain high, which will be a tailwind for growth. Despite the company’s net debt $1.2 billion, it has more than $500 million in liquidity when accounting for its cash and revolving credit facility, which should help it withstand any economic weakness. Upbound Group is a Buy Despite its considerably faster growth, the company’s shares trade at a low valuation and at a discount compared to its peers. I believe the strong growth in Acima will likely continue in upcoming quarters, allowing the company to outperform its guidance. Though the company faces risks relating to a weakening economy, I believe that it is more than compensated for by its undemanding valuation. Therefore, I like the current risk-reward and rate it as a Buy.

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