What Are the Risks Facing Upwork?

Upwork (UPWK -1.58%) is in a strong financial position and has a huge growth runway ahead of it, but what are the risks that investors need to be aware of?

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 management team and internal culture, and check for red flags that could cause the company to stumble.

A full transcript follows the video.

This video was recorded on Oct. 26, 2018.

Dylan Lewis: Brian, with this fifth one here, I think this really gets to something that is core to the Foolish investing outlook. We want good businesses that are going to be sustainable, are going to enjoy some great tailwinds that will push them to growth, but we also want to make sure that management and the corporate culture supports a long-term vision for this company, as well, that people are being treated correctly.

Brian Feroldi: Yeah, that is something that I think the best companies do have in common. They attract and retain talent. Upwork is located in Mountain View, California, which is in the same area as Apple and Alphabet and Facebook. They are competing against companies that are well-known for treating their employees like gold. One of the things that I like to do with any stock that I'm interested in is check out what employees say about them. You can use websites like Glassdoor and Comparably to get a feel for how employees think that they're treated. Another thing I like to look at is inside ownership, how much the insiders own of the stock, how long they've been there. Ideally, you'd like to see that companies that are less than 20 years old still have the founder involved.

When I look at Upwork today, Upwork as we know it was formed back in 2015 when two online freelance marketplaces called oDesk and Elance were merged together. The founders of Elance have since moved on, they're not there anymore. One of the co-founders of oDesk is Upwork's CTO, which is a good sign. Having said that, his other co-founder left the company in 2015.

Upwork's CEO, Stephane Kasriel, joined the company in 2014. He's only been there for a handful of years. He does own about four million shares of stock, which is about 4% of the company. That's a decent amount of skin in the game, as we like to call it. If you look at the executive team, in general, including officers and directors, they own about 40% of the combined company.

Lewis: That's what we really like to see. The people that are making these decisions for the company are bought into the long-term success of the company.

Feroldi: Exactly. You want to see that the executives and the people that are in charge will get burned very badly and feel the financial pain if they make decisions that are not in the long-term health of the company.

Going back to the Glassdoor ratings, Upwork gets about a 3.6/ 5 on Glassdoor. About 62% of employees would recommend it to a friend. The CEO gets an approval rating of about 74%. That's OK. That's not stellar, off the charts fantastic, especially when this company is going to be competing for talent in Silicon Valley. I would like to see better Glassdoor ratings. But they're not terrible, I guess, is the key takeaway.

Lewis: Nothing atrocious there, but it is not a huge selling point for the stock. You're not like, "The numbers are OK, but people love working there, that's a competitive advantage." It's more of like, "Eh, it is what it is."

Feroldi: I think that's exactly the right way to look at it.

Lewis: Why don't we turn our attention to your sixth piece of criteria? That is the red flags and the things that people need to be aware of with this company. What stands out to you?

Feroldi: Experience has taught me the hard way to never invest in penny stocks. This company is worth $2 billion, trades for about $17 a share or something like that right now. It's in no way a penny stock. Another thing that has burned me in the past is when a company is overly dependent on a handful of customers for the majority of their business. In Upwork's case, it has thousands of paying customers, and the largest one was only about 2% of revenue, so that's not a concern at all.

Another thing I like to see is that a company is riding a long-term tailwind, as opposed to facing some kind of headwind where a market is shrinking. I think it's very fair to say that the market for freelancers is growing very quickly. This company certainly has the wind at its back.

I also want to make sure that the company isn't overly dependent on something that's outside of its control for success. An example of that would be an oil company that is highly dependent on the price of oil, or a bank that's highly dependent on interest rates. Those are factors that are outside of their control. In Upwork's case, I don't see any factor that would prevent its success other than something that was inside its own execution control.

And then finally, I look at stock-based compensation. I don't want excessive stock-based compensation. In Upwork's case, the first six months of the year, stock-based comp was $3.6 million. That's very, very small when compared to the $120 million in revenue that it generated and its market cap of about $3 billion. So, I have no concerns there.

Lewis: I want to dig into that excess customer concentration point you make there. I think that's something that can really be overlooked with a lot of businesses. Not that it's something that automatically makes something a buy or not buy. But particularly in the as-a-service segment, if you are serving a very concentrated group of customers, your results can be very lumpy, and you can take some really big hits related to companies deciding to go do things on their own or use another provider. I think of Twilio really specifically when we're thinking about customer risk. They were the end-all-be-all when it came to these building blocks on the developer side, and all of this communication that would happen in-app. They were so perfectly positioned for companies like Lyft and Uber to use them for all of their communications within their ride hailing apps. Well, ultimately, Uber, who was somewhere north of 10% of their business, decided to move away from them. This is a company that's done very well, but took a huge hit immediately after that, because a lot of people realized that the revenue that was coming in from that company just wasn't going to be there anymore. That is why I think this is such a good thing to focus on.

Feroldi: Yeah, absolutely. If a huge chunk of business is reliant on one customer, and that customer chooses defect, for whatever reason, the company can be in some serious trouble very quickly. I've learned the hard way that you have to check for that with every company you invest in.

Lewis: Most lessons are painful lessons, Brian. [laughs] Hearing you talk about this, it sounds like you're pretty bullish on this company.

Feroldi: Overall, I think that Upwork checks the majority of the boxes that I look for. I don't think it was perfect. No business is. But overall, I think that the company has a business model that is very attractive. It's riding a wave. It's the top dog. It has such an enormous opportunity that I think there's reasons to be bullish.

Having said that, when companies go from the transition from private market to public market, it's a huge cultural shift for them. Some companies do great as new public companies. Other companies fail. I never personally like to buy companies right after the IPO. I always like to give them at least, say, two quarters and see how they handle being a public company. What's it like to have an earnings expectation placed on your head for every 90 days? I like to follow a company's progress and see how they perform as a public company before I would get interested.

What I want to see from Upwork is for them to blow out their first two earnings reports and have everything go well. If that was the case, I would be a happy buyer of this stock, even if the price was much higher than it was today, because I would have much more confidence in their ability to be a public company.

Lewis: There are a couple of other reasons I think that's a great outlook, too. When a company first goes public, there generally aren't a lot of shares out there for people to buy. You have a lot of volatility with share price just because some shares are locked up and unavailable on the public markets. Like you said, you want people to have to deal with the scrutiny of being a publicly traded company. It's very different than being private. You want to see how management handles that.

I am very much in your camp. I think this is a really compelling stock. I love the tailwinds and I love the very clear path to profitability that I think we see with this business. I will probably be watching it the same way you do, where you're rooting for good results, but hoping that the share price doesn't go nuts because you ultimately want to add to the position at some point.

Feroldi: I think that's the right way to approach this stock or really any new IPO that comes out.