Gig work is booming: It's projected to balloon to a mind-boggling $2.7 trillion by 2025. Did we mention that the world's biggest freelance platform just went public? Because the world's biggest freelance platform just went public.
In this episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Brian Feroldi dive into the fundamentals of Upwork (NASDAQ:UPWK) and explain what investors need to know before buying in. How does Upwork make money? Does it have a path to profitability? How does it compete against its peers? Does it have any pricing power? What risks should investors watch out for? Does management have skin in the game? Find out more below.
A full transcript follows the video.
This video was recorded on Oct. 26, 2018.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, October 26th, and we're breaking down another big tech IPO. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com's Brian Feroldi. Brian, what's going on?
Brian Feroldi: Not much, Dylan. I just got back from a lovely bike ride because it's a beautiful day here in Rhode Island, and I can do that because I live the freelance lifestyle.
Lewis: What a great queue-up for our topic today! Yeah, you're a contractor, and you write for our site, and you enjoy the benefits of being a contractor. You don't have to be at a meeting at 12:30 in the afternoon.
Feroldi: That's right. And I tell you, when you have small children, having complete control over your schedule is a godsend. I love the lifestyle.
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?
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 monthlong-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.
Lewis: You have this strong business with high switching costs and a lot of people that are drawn into it. One of the most appealing things for me, though, is the long-term trends that this company plays on. This brings us to criteria No. 3 for you, potential. This company is really at the center of the gig economy, which has blown up over the last couple of years, and I don't think it's going to stop anytime soon.
Feroldi: Yeah, that's something that I totally agree with. There is definitely a push toward hiring freelancers and people taking on side jobs. Right now, over the last 12 months, about $1.5 billion worth of transactions took place. They call it gross service volumes on Upwork's platform. That number has consistently grown by 20% over the last couple of years. From that number, Upwork takes a cut from both freelancers as well as from the clients. They charge fees to both sides. That $1.56 billion in growth service volume trickled down to about $230 million of revenue. They take about 14% or so of the total payment volume that goes on their network.
That $1.56 billion sounds like a big number, but even today, the estimate is that their total addressable market is about $560 billion. If you believe that number to be anywhere close to accurate, this company has an enormous runway of growth ahead of it.
Lewis: One thing I want to clarify in talking about the numbers here, you mentioned that gross service volume. That is a somewhat company-specific metric that some investors might not be familiar with. You also likened it to total payment volume. If you're an investor that follows PayPal, the principle is pretty much the same. It's the value and the volume that is being facilitated on that platform, not what that company is necessarily taking in from those transactions.
Feroldi: That's, correct. What's exciting, as you mentioned before, if you're a believer in the rise of the gig economy, as they're calling it, McKinsey put out a study where they estimated that the total amount of freelance work that will happen by 2025 will be about $2.7 trillion dollars. Compare that to what Upwork did over the last 12 months of $1.56 billion, and I think it's pretty fair to say that even if that estimate is off by an order of magnitude, the runway ahead of this company is enormous.
Lewis: Criteria No. 4, this is customers. This is really looking at, how do customers interact with the business? Does this look like something that's sustainable and serves people well?
Feroldi: Yes. Customers are the lifeblood of any business. I like to think about the way that customers interact with any business. Some of the things that I looked at is, how much does it cost to acquire a new customer? This is a key metric for a lot of businesses. Every day, about 10,000 freelancers and agencies sign on to Upwork's platform. That growth is not free. There is some organic, but Upwork does spend about $70 million per year in sales and marketing costs to get that on there. That growth is not free, but I think that's money well spent.
The second thing I looked at is, how dependent on the company are the customers? Between 2015 and 2016, the amount that an average business spent on Upwork's rose by about 106%. The customers that they kept tend to spend more on Upwork's platform over time, which is a great sign that the businesses that are signing up are very dependent on Upwork's network.
The third thing I looked at is, is the revenue recurring? I do not like businesses at all where it's a one-time customer transaction. The customer buys something, and then they disappear. I like it when they have a relationship with the company and they continuously buy from the same company over and over again. I think you can say that Upwork's business is repeat purchase. Once they sign on and offer projects, they are more likely to offer new ones.
The final thing I looked at is, do I believe that the company could establish pricing power over time? Do I think that they could raise prices faster than inflation, and not lose any business? Theoretically, I believe that Upwork could as it becomes the largest because it's the largest platform in the world. I think that eventually, both freelancers and clients will become heavily dependent on Upwork to make that connection. Having said that, the gross margin that we saw on Upwork did decline about 100 basis points between 2016 and 2017. I'm not terribly concerned about that yet, because the business is in hyper-growth mode and they're investing all over the place, so that much of a decline doesn't bother me. But ideally, you'd want to see that their gross margin expands as the business gets bigger.
Lewis: Investors listening at home, if you want a number that is kind of the catch-all for what we're talking about here, Upwork has this client spend retention number. This is what Brian was talking about with that 106%. You can think of this the way that a restaurant has comps, basically. You have an account that has been active for a certain amount of time. They look at, basically, what has been spent in the past year? How does that compare to what they spent in the 12 months prior to that period? You want to see that number going up and to the right, ideally over 100%, because that means people are using the platform more and maybe there's the opportunity to upsell, and people are taking those chances to upsell. We love to see that, particularly in the software as a services segment.
Feroldi: That's absolutely correct. One of the things that Upwork could do over time is roll out new features, roll out new services, and generate more revenue from their current base of clients. That business model is very attractive for investors.
Lewis: Particularly when you already have a very large group of people using your services. We've got two more categories that we're going to look at on Brian's checklist, management and red flags.
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.
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.
Lewis: Thanks for sharing your thoughts, Brian, and thanks for sharing the freelancer perspective. I appreciate it!
Feroldi: Anytime! Happy to be here!
Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you want to reach out and say hey, you can shoot us an email at firstname.lastname@example.org, or you can tweet us at @MFIndustryFocus. If you want more of our stuff, you can subscribe on iTunes or catch all the videos of the podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass! For Brian Feroldi, I'm Dylan Lewis. Thanks for listening and Fool on!