How Does Upwork Work?

With more than 375,000 freelancers and 475,000 business on its platform, Upwork (UPWK -3.70%) has become the go-to partner for freelancers and employers alike. But is this company in good financial shape?

In this episode of The Motley Fool's Industry Focus: Tech, host Dylan Lewis and Fool.com contributor Brian Feroldi take a closer look at Upwork's financial statements and competitive position to figure out if the company is poised to thrive over the long term.

A full transcript follows the video.

This video was recorded on Oct. 26, 2018.

Dylan Lewis: Today, we are going to be talking about a company that helps people live that lifestyle. We're gonna be talking about Upwork. This is a company that just went public, and it's actually a company that The Fool uses quite a bit. We use it to manage our contractor relationships, both in editorial and with some of our tech projects. It's a pretty incredible platform. Why don't we get into how this company makes money and what they do to kick things off?

Brian Feroldi: For people that don't know, Upwork is the largest online freelance marketplace in the world. They bring together freelancers who are looking for gigs and employers who have projects or jobs that they want to do, and they basically match them up. It's kind of a win-win situation for both sides. If you're a freelancer and you have skills, you can go to the site, log in, and browse through jobs that might interest you, and you can apply for those jobs. You can do that as a side hustle to earn extra money in addition to your regular job, or, if you have enough volume, you can basically do that full time. For employers, it's a way for them to instantly access a pool of talent. Upwork claims that they have basically 70 categories of work and they have 5,000 different skills within those categories. If they need instant expertise with anything like graphic design, accounting, data analytics, search engine optimization, and dozens more, they can quickly find an expert that they need and hire them. In fact, Upwork likes to say that the average time to go from posting a job to having somebody starting work is about 23 hours. That is lightning fast.

Lewis: So much of the value prop of this business is connecting businesses with qualified individuals. They really tout the fact that so many of the freelancers on their platform either hold baseline degrees, advanced degrees, very special skill sets. You have employers that are looking at people that are qualified to do the type of work that they are looking for, which is huge. They say that a lot of the jobs, a lot of the things that become available for workers to work on, there are qualified candidates coming in within the first 24 hours on Upwork, which is a testament to how much quicker this allows companies to get things done, compared to a month-long type situation that you often have when you are hiring for a full time job at HQ for a lot of companies.

Feroldi: That's exactly right. That's the big benefit that they bring. To give you a sense of their scale, they have 375,000 freelancers and 475,000 paying clients on the platform today. That list of clients includes about 30% of the Fortune 500. These guys are the top dog in the space.

Lewis: Brian, one of the reasons that I wanted to have you on this show was, you put together an awesome breakdown of Upwork. That's available on fool.com. It's a great rundown of what this company does and it's very methodical. I particularly loved it, though, because it gives a great look at how to break down a business and whether it's investment-worthy. We are going to essentially walk through that on the show. If listeners would rather read any of this, you can just email the show and we'll make sure to send it out to you. Just getting that out of the way.

The first criteria in your checklist for breaking down these businesses is a look at the books. What do you see when you're looking at Upwork?

Feroldi: Like you said, I have a checklist that I've developed over the years. Anytime I come across a business that I'm interested in, I basically just go top to bottom on my checklist and look at everything that I can find about a business so that I can come up with a ranking system to compare it to other businesses.

As you said, one of the first things I start with is financials. When I look at Upwork's financials, as you said, they just went public. During their IPO, they raised about $187 million before fees. About $95 million of that went into the company's bank account. About $78 million of those proceeds went to insiders who were looking for an exit. The company did not get 100% of the proceeds.

Having said that, they did use the money that they raised to retire some of their debt. After the IPO, their balance sheet has $112 million dollars in cash and their debt load was reduced to just $24 million. They have about $80-90 billion in net cash on the balance sheet, which is great to see.

Lewis: Yeah, this is not a company that is over levered or sitting on way too much debt that would be unsustainable for them to make payments on. They have a nice cash balance there that should be able to cover that for the time being. This is not a profitable company, though, at the time.

Feroldi: Correct. Upwork is purposely choosing to reinvest as aggressively as they possibly can into building out their business. That's a decision that I think is the smart move to make. Operating a platform business like this, scale is everything. Freelancers are naturally going to want to go to the place that has the most job listings. Conversely, businesses are going to want to post jobs on the site that has the most freelancers available. Upwork is purposely operating at a loss so that they can grow as quickly as possible.

Having said that, their loss for the first six months of 2018 was about $7 million. However, over the same time period, they generated about $8 million in free cash flow. Their bank balance went up by $8 million, so they are technically unprofitable. However, that doesn't concern me at all because they have such a huge cash balance on their balance sheet after the IPO and because they're producing free cash flow.

Lewis: That small loss came on somewhere in the neighborhood of $220- 230 million, something like that, for the first half of 2018. In 2017, they did $203 million, which is up over 20% year over year. When you are looking at a company, and the pitch is, "This is going to be a high-growth company. There are a lot of tailwinds that this company can ride. They're not profitable, though," what you really want to check is, long-term, is the profit in place? Can you envision this company eventually turning a profit and really switching the engine there? And I think yes for this company. They are not losing money because this is operationally a bad business. In fact, their gross margins are great. It's really just that they are choosing to invest now to grow the business, and then they'll worry about profitability a little bit later.

Feroldi: That's exactly right. To the margins, their gross margin over the last six months was about 67%. That's something that I want to see. Ideally, you'd like to see that their gross margin grows over time as the business gets bigger, and they can scale more and more fixed costs over a larger base of business. That's something that I look for. Their gross margin has not increased over the past year. I'm not terribly concerned about that yet. But that is an area that I'm going to watch going forward.

Lewis: Got it. The second criteria in your checklist is moat. This is something you hinted at a little bit before when you were talking about the draws of the platform. This is a business that really benefits from the network effect.

Feroldi: Yeah, exactly. Broadly speaking, there are four different types of moats. I won't make an investment in a company unless I believe that the company has a durable competitive advantage over its competition. I think that you can safely say that Upwork, because it is the biggest platform for freelancers, does benefit from the network effect, like I said before. They have the most freelancers and they have the most clients. Both of those want to be where the biggest pool of applicants is. Right now, I do think it's safe to say that Upwork is benefiting from the network effect.

You could also make an argument that the brand name Upwork is valuable. You could also make an argument that their clients do have some switching costs if they wanted to move to a different platform once they get verified and set up. But by and large, the long-term competitive advantage is the size of the network.