UpWork Inc. (NASDAQ:UPWK) recently appointed Jeff McCombs as its new Chief Financial Officer. Now imagine that you are Jeff. You want to get a solid understanding of the business model, the drivers of value creation and profitability. A good place to start is to look at the income statement over the last few years.
There are two things that stand out. Firstly, UpWork has been growing steadily. Secondly, Upwork is not profitable. In fact, UpWork has reported a net loss every year from 2016 to 2020. This is not necessarily a bad combo.
Amazon was notoriously unprofitable for a long time while growing rapidly. John Malone – a regular savant when it comes to financial engineering and tax efficiency – confused analysts for many years by operating TCI without a profit while growing rapidly. What we need to get a better understanding of is the cost structure of the business.
better understanding of is the cost structure of the business.
UpWork’s Cost Structure
If you look at the income statement, you will notice that UpWork generates revenues at a noticeably high gross margin. Cost of Goods Sold is less than 30%. According to some research, high gross profitability is a positive indicator of future profitability.
Looking further down on the income statement, you will see that most of UpWork’s operating expenses are split into three categories:
- Research & Development
- Sales & Marketing
- Administrative Expenses.
As you would expect, there is a spike in administrative expenses after the IPO. The other two cost segments are worth a closer look.
Research & Development
UpWork was incorporated in 2013 with the combination of Elance and oDesk, the origin of Elance dates all the way back to 1999. There is more than 20 years of software development behind UpWork.
Yet if we look at the most recent Balance Sheet (2Q2020) the total value of intangible assets is just over $2 million. In the footnotes to the financial statements, under Intangible Assets, it says: “All of the Company’s identifiable intangible assets were acquired in March 2014 from the Elance-oDesk Combination.”
Obviously, after 20 years of development, the software and product is worth more than $2 million. What this tells us is that UpWork does not capitalize any of its spending on software development. It all goes directly to the income statement. Yet, much of the value it creates will last much longer than the specific quarter wherein it is expensed.
Put another way: During the second quarter of 2020, UpWork spent over $20.5 million on Research & Development. An amount ten times the size of the intangible assets on the company’s Balance Sheet. It is safe to assume that many of the software features that were being developed during the quarter, have not yet started to generate revenues for UpWork.
Sales & Marketing
Similarly, the business that UpWork acquires through its sales and marketing efforts will to some extent be retained. One of the key performance metrics identified by UpWork is Client Spend Retention, which basically answers the question “how much business did we retain from our client base over a twelve month period?”
In 2019, Client Spend Retention was 102%. That means that the cohort that was defined as Base Clients in 2018, collectively spent 2% more in 2019 compared to the spending in 2018. Therefore, some of the Sales & Marketing costs that UpWork spends on client acquisition will be producing revenues for UpWork far beyond the particular quarter in which they are expensed.
Furthermore, it should be noted that UpWork has been investing aggressively in attracting Enterprise Customers to its platform. This has required them to set up a specific sales department and sales processes for enterprise sales. Enterprise sales have much longer sales cycles than the sales funnels from smaller businesses. But the spoils are bigger. In relation to costs, they will stretch out the conversion of costs to revenues for Upwork.
You may be familiar with Warren Buffett’s concept of Owner Earnings. His argument is that in most cases you will have to adjust the earnings number that a company reports to reveal the actual earnings that belong to the shareholders.
In Buffett’s case, he is arguing for backing out Depreciation and Amortization from the Net Income and adding the amount of Capital Expenditures required to maintain earnings (thus excluding Growth Capex).
In the case of UpWork, the company is cost accounting expenses that to some extent are longer-term investments. So the question is: what happens if we adjust the UpWork earnings by capitalizing some of the cost of Research & Development and Sales & Marketing? Would that give us a more accurate picture of what the actual Owner Earnings of UpWork are (by excluding Growth expenses)?
To take this thought forward we can see what happens if we were to capitalize the Research & Development and Sales & Marketing costs of UpWork. What would have happened if UpWork had capitalized those costs from 2016 and depreciated them over a 3 year period?
Under this scenario, the Adjusted Operating Income (pre-tax) is now showing a profit above $25 million for both 2018 and 2019. But by capitalizing the expenses we are moving them to the Balance Sheet. By doing that, the business becomes asset heavier and that would affect the Return on Net Assets of the business.
So, to get the whole picture, we need to look at the Adjusted Balance Sheet as well:
As we can see, under this adjusted premise, the business earned a Return on Net Operating Assets (RNOA) of 16.5% in 2018 and 18.6% in 2019. Decent but by no means stellar. But that’s not really the point.
The accuracy of these percentages is deceiving and should be taken with a grain of salt since this is merely a thought exercise. Using 3 years as a rate of amortization, for example, is arbitrary. We don’t really know to what extend the sales and marketing expenses are to retain customers. The list goes on.
The key point is that much of the costs that are being expensed on UpWork income statement are indeed more akin to investments in growth. As such, the future revenues that they will generate are yet to materialize.
And yes, irrespective of the GAAP accounting, I do think that UpWork is operating profitably.
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