Description

This is the 5th time Upwork (UPWK) has been written up on VIC. There’s a lot of background on the company/industry in those write ups and I recommend reading them. In short, Upwork is an online marketplace that earns a fee for pairing employers to freelancers. Freelancers get access to clients while clients get access to freelancers faster and cheaper than they can from traditional channels. The long-term growth in the penetration of freelance labor has been propelled by the flexibility for both freelancer and employer as well as speed and cost advantages for employers. The pandemic has both normalized and proven the efficacy of remote work, removing additional roadblocks from the industry’s path.

I believe UPWK is compelling at today’s levels for the following reasons:

1)      Competitors are vertical specific and/or serve a particular niche

2)      There is a long runway for growth in a post-pandemic world where freelancing and remote work have been normalized

3)      The company isn’t profitable, but could achieve profitability if prioritized

4)      The stock is a broken COVID winner, off ~85% from its highs last year and trading at sub 3x gross profit

5)      The Upwork marketplace is a unique and strategic asset for potential acquirers

Marketplace Competition

There are many freelance marketplaces, with most focused on a specific vertical or with some sort of differentiating value prop. Turing, for example, is focused on software developers. Toptal differentiates itself by quality of talent, allowing only the ‘top 3%’ of freelancers onto the platform. The Mom Project is a marketplace of women who’ve left the traditional work environment to become moms. Upwork and Fiverr (FVRR) are two of the broadest platforms as they are both scaled across many different verticals. But even here, the two platforms differ from each other in that Upwork is more professional focused while Fiverr is more gig focused. The average active client on Upwork is an SMB that spent $4958/year on the platform while Fiverr’s spend per buyer is way lower at $262/year.

Growth Runway

It’s easy to start a freelance marketplace, but difficult to scale it. Barriers to scale should theoretically allow scaled marketplaces to earn decent economics. These economics have been merely ‘theoretical’ because we’ve been in an environment that’s favored growth over profits. UPWK’s Gross Service Volume (total client spend through the platform) will grow around ~17% in 2022 after growing 41% in 2021 and 21% in 2020. Undoubtedly there has been a COVID bump in demand, but GSV still grew at a 22% CAGR from 2016-2019:

UPWK calculates its $1.3 trillion TAM as 225 million remote workers earning $5,850 average GSV.

Fiverr estimates that 6.1 million freelancers in the U.S. (3.8% of the civilian labor force) earned $234B in revenue in 2020. That’s $38,200/year, or $26/hour from 28 hours of work per week on average. This includes both online and offline workers, but for the categories in which FVRR operates, it estimates its addressable market in the US at $100-$115B with the European addressable market 1.5x larger. It also estimates that online marketplaces are only 5% penetrated.

Alternatively, the American Staffing Association estimates 2021 temp/contract staffing revenue of $144B in the US.

All of these attempts at sizing the TAM have problems, but at ~$4.2B of GSV (2/3rds of which is from US clients), I’m confident that UPWK can grow GSV at a 15-20% rate for many years before bumping up against the edges of its market.

Profitability

UPWK has generated positive adjusted EBITDA since 2016, albeit after big stock comp add backs. Adjusting those out shows a company growing GSV at 20%+/year at near breakeven EBITDA levels:

The falloff in profitability from 2020 to 2022 can be explained almost entirely by the company’s aggressive growth in brand marketing spend, which increased as a percentage of revenue by ~10%:

Beyond brand marketing, the company has been investing in its nascent enterprise offering. This includes R&D spend and a completely separate sales force. The enterprise offering provides larger businesses with higher service levels, acting more as a replacement for traditional staffing. Enterprise customers get access to a dedicated pool of higher quality freelancers and are assigned UPWK employees to help onboard freelance teams, write job posts, screen talent, and manage project delivery. Customers also get access to employment compliance solutions, management platforms, payment/invoicing systems, and approval automation tools.

Management is targeting $300 million of enterprise revenue by 2025, up from a $50 million run rate today. Growth in the enterprise offering stumbled in Q3, for which the company blamed “operational growing pains and external sales cycle elongation”- a combination of executional missteps and the macro environment.

As for where UPWK’s margins land at maturity, CFO Jeff McCombs (who is leaving the company at the end of the year) put forward guidance of breakeven adjusted EBITDA margin in 2023, growing a few hundred basis points each year until the company reaches a targeted long-term adjusted EBITDA margin of 30-35%. That’s roughly a 20-25% EBITDA margin including stock comp as an expense. For a company with 74% gross margins today (and above 80% if you adjust for the different accounting treatment of ‘managed services’), the low end seems reasonable.

Gross margins can increase by 5-10% toward management’s target of 80-85% as the company transitions payments towards cheaper rails like ACH. Credit cards cost 2-3% on GSV, which is a big deal relative to a take rate of ~15%. Take rate should increase as well due to above average take rates on the faster growing Enterprise, Talent Scout, and Project Catalog products, partially offset by pressure from higher spend per client (the take rate is tiered downward with additional volume). Additionally, as managed services become a smaller piece of the business, the mix shift is positive for gross margins as managed service revenue is recognized on a gross basis.

Brand marketing, as noted above, is responsible for 10 points of margin in the sales and marketing line.

The company should also get leverage on G&A, although stock comp, largely from grants to management, has suppressed that leverage on a GAAP basis.

It’s not a perfect comparison, but the public staffing companies have EBITDA margins north of 20%. I think freelance marketplaces have a good chance of at least being able to match that.

The following is from UPWK’s October slide deck:

These numbers don’t include stock comp, but directionally they’re not unreasonable.

It’s also relevant that UPWK’s client spend retention has been 100%+ in normalized environments (the red box is the period of integration between the oDesk and Elance platforms, UPWK’s two predecessor marketplaces):

As far as whether the company will prioritize profitability, UPWK’s CEO has a history of making tough choices when she needs to. In late 2020 she shut down the small business product and cut 1/3 of the sales force when it became clear the company couldn’t earn an adequate return on the spend. I believe she will do the same with brand marketing spend if she determines it’s not earning a reasonable return.

Strategic Asset

I believe that UPWK is a strategic and unique asset that a number of companies should want to own. The temp worker industry is traveling towards an integrated model, allowing a client to select between full service and self-service solutions. UPWK is traditionally a self-service model but its enterprise product is a clear shot across the bow of the traditional staffing industry. Even Fiverr is moving up market as it targets small businesses. Meanwhile, some staffing agencies are trying to recreate freelance marketplaces or offer hybrid solutions like digital self-service staffing products. The RHI CEO said the following in the company’s July 2021 Q2 conference call:

"I'd say, at 50,000 feet, we've long talked about this continuum of traditional staffing on the one side, talent platforms, self-service driven on the other with the latter giving clients access to our technology, given access to our candidate database, which is second to none for professional-level people. We're still about building out that other side of that continuum. We've made significant progress. We hope in the next few quarters to have at least a minimum viable product ready to go to market there. But our vision is that clients, not we should choose how much they want to interact digitally versus how much they want to interact traditionally.

And quite frankly, our belief is that while many might first come to us thinking they want to do it digitally self-service, it will ultimately become lead-gen as they find that they need more help closing candidates. And therefore, benefiting the traditional side simply by having the talent marketplace, the self-service solution that would be principally digital. It would start is all digital."

While RHI has the capacity, an acquisition of this size would be out of character for the company, which hasn’t made a transformative acquisition in many years and doesn’t operate with much debt.

Adecco is probably not in the market as it spends the next couple of years working down its leverage from the acquisition of AKKA. Interestingly, Adecco attempted to build an Upwork competitor, called YOSS, in partnership with Microsoft. It shut YOSS down in 2020:

“When we launched YOSS and we developed this platform, the purpose was to create a kind of generic platform.

Now after this experience we have done, we have seen that it was rather difficult to get to critical mass with a kind of generic solution and service offering. But it would be much more appropriate to leverage the learning, the technology we had gone through with YOSS in the various brands. Because, yes, if you're an IT freelance, you will be more attracted by Modis than going to YOSS. If you are an interim manager, you will be more attracted to go to, for example, Badenoch & Clark interim management rather than YOSS. So that's why we had decided to, I would say, cut our losses, and that's the way we should do as entrepreneurs and integrate and develop the proposal through the verticals and through the brand.”

Adecco folded YOSS into its vertical specific brands. Meanwhile, Microsoft has since become one of UPWK’s biggest enterprise customers.

Valuation

Coming up with a fair value for UPWK is tricky given the lack of profitability, but that’s part of the opportunity as investors have completely soured on unprofitable companies. Making an argument about terminal margins or what a company could earn if it prioritized profitability is a tough sell right now.

UPWK trades at 2.0x 2022E revenue and 2.7x 2022E gross profit. That seems low for a scaled marketplace and strategic asset with ~74% gross margins and normalized client spend retention above 100%.

One could have made a similar statement at 4x gross profit or 5x gross profit (and many did), and yet the stock is down substantially. I don’t know where the floor is, but it’s now at a point where it looks cheap using reasonable assumptions on terminal margins.

Assuming a 20% “look through” margin, the stock is priced at ~10x 2022 EBITDA.

Things I worry about

1) The chart looks atrocious and I’ve made bad mistakes catching falling knives in the past.

2) We’re heading into a recession. The Fed is intent on reducing employment, ie. literally UPWK’s market.

There is a narrative that UPWK can thrive in a disruptive macro environment as businesses prefer lower cost/lower risk freelance solutions instead of permanent employees. That might be true, but I find it hard to believe considering the cyclicality of staffing companies which should be subject to similar tailwinds. In reality, companies cut their temp workforces first. On the other hand, they recover first too.

Upwork serves mostly small/medium businesses. Freelance marketplaces are constrained by the client half, which is why their sales and marketing is predominantly focused on that side of the marketplace. When small businesses get wacked in the downturn, I expect it to negatively impact Upwork.

3) Freelance marketplaces did have a COVID pull forward and companies have been exploring every avenue to find employees in a stretched labor market. I expect that to unwind, but I also find it hard to argue that the pandemic wasn’t a big long-term net benefit in terms of normalizing the use of remote workers and freelancers.

I don’t know how to forecast how this is going to play out the next couple of years, but the sell side numbers look too optimistic right now. Waiting until consensus numbers come down might provide a better entry point.

UPWK is in a net cash position with $676 million of cash and marketable securities on hand, offset by $575 of busted convertible notes due mid-2026. This at least gives the company some breathing room for a few years.

4) It was announced in late September that the CFO, Jeff McCombs, is leaving the company at the end of the year. The company has hired a search firm to find a new CFO. I haven’t been able to get much detail on why, but it appears to be a mutual decision. He’s going to be taking some time off after he leaves UPWK.

I’ve only heard good things about the CEO, Hayden Brown, who seems to be well respected. In January 2021 she received a huge performance award of 1.5 million options, worth almost $30 million. The exercise price is $38.80/share, and the performance vesting requirements start at $60/share. With the stock touching the single digits today, the board is going to have to rework some incentives here.

Catalyst

 Growth/M&A