Upwork (UPWK) IPO Valuation

The objective of this article is to estimate the intrinsic share value for freenlancing platform Upwork, which went public on Oct 3rd. The estimate is arrived at using a DCF valuation based on the company fundamentals given in its S-1 prospectus and my own views/forecasts on the company

Disclaimer: The intent is certainly not to give buy/sell recommendations and also I do not own any stock of the company

I have come up with a point estimate share value of $15.1. The IPO issue price of $15 looks fairly valued. The IPO listed at $23 i.e ~53% premium. The stock now trades at $21 per share and looks overpriced as of this writing (10/5/18)

Devil is in the details (the not so good part) :

1. As per the S-1 prospectus, Upwork does not calculate or track freelancer retention metrics. I believe that tracking talent retention (just as tracking customer retention) and taking steps to plug any attrition is essential to any talent platform
2.  Although, in 2017 and the six months ended June 30, 2018, almost 50% of client spend was from clients that had used the platform for longer than three years, however, the absolute spend by these clients have shown a marginally declining trend from the time they first spent on the platform
3. Accounting evils –
   1. Employee stock options have not been expensed i.e. they are not used to arrive at Net Income in the P&L and are hence present in the Cash Flow (CF) statement and the equity section of the Balance Sheet (BS)
   2. Net losses by using derivative instruments have not been expensed and are hence present in both the CF statement and the BS.

The Impact due to the above is an illusory positive impact on the Cash Flow statement and low expenses resulting in less negative Net Income

3. R&D has been expensed instead of being capitalized

4. Operating Leases have been expensed instead of being treated as a lease asset

I have fixed 3.1, 3.3 and 3.4 in my valuation. I couldn’t fix 3.2 since the extent of net losses is not mentioned in S-1

I treated Stock based compensation as an expense and added back R&D compensation to reported EBIT to arrive at adjusted EBIT

Then I went on to use Black Scholes to value the outstanding 22.93 mn options at *$285.7 mn and eventually deducted it from my estimated value of equity to arrive at equity in common stock and subsequently got a reduced value per share. This might seem like double dipping (i.e treating stock based compensation as an expense and then deducting stock options from value of equity), but its not. Dean of Valuation and renowned NYU Stern Prof. Aswath Damodaran has brilliantly explained the treatment of stock based compensation in valuation  

*I used the IPO issue price of $15 as the stock price, 3% Risk Free Rate, weighted expiration of 7.2 years and standard deviation of 38.4% (as mentioned in the prospectus) in the Black Scholes forumla to arrive at Options value

Next, I capitalize R&D which has a positive effect on reported EBIT and also gives a tax benefit on resulting the amortization of the last year

Lastly, I take find the present value of future lease commitments and this value ($3.37 mn) to total debt. This is our operating lease asset. I depreciate this and deduct the depreciation ($0.67 mn) from the current year’s lease commitment ($3.6 mn) to determine the adjustment to be made operating income – i.e. I add $2.93 mn to EBIT

Fixing 3.3 and 3.4 have a positive effect on EBIT with the result that I get an overall positive value of EBIT $24.89 mn from -$15.62 mn

Absolute Valuation

Free Cash Flow to Firm or FCFF is used to estimate Free Cash available to both debt and equity holders. It is arrived at by estimating cash flow generated from operations or the Net Operating Profit After Tax EBIT(1-T), some of which is re-invested back in the firm. Any cash over and above the re-investments is available to both debt and equity holders. This is called Free Cash Flow to Firm (FCFF). Present Value of future FCFF is the Enterprise Value (EV). Additionally, removing present debt from EV and adjusting for stock options leaves us with equity in common stock

Facts->Stories->Numbers

Before jumping into the valuation we need to have a story spun around facts, which is essentially what we think of the company, the industry, market size, growth potential, margin, investments needed to drive and sustain growth, capital nature of business – intensive/light/efficient, period of high growth and the transition to stable growth, business risk and the interplay of competition among other things

Now, lets take a look at the above objectively and attempt to tie certain facts it to our story

 

A. Fact: Market Size & Growth

• As per McKinsey, the total global Gross Service Value (GSV) opportunity for freelancing platforms was approximately $560 billion in 2017. By 2025, online talent platforms could add $2.7 trillion annually. This represents a 21% increase Y-o-Y.
• Upwork GSV grew by 30% period-over-period (for the 6 months period ending June 30, 2017 and June 30, 2018), primarily driven by a 22% increase in the number of core clients
• Upwork revenue grew 23% annually in 2017 to $202.6 mn and also revenue grew 28% period-over-period

A. Story: Coupling the above with increased investments in R&D and Marketing & Sales in the last 2 years makes me believe that revenue could grow at 25% Y-o-Y

B. Fact: Growth Period

• Typically, the revenue growth rate of a newly public company outpaces its industry average for only 5 years

B. Story: Since we have only one other publicly traded freelancing platform i.e. freelancer.com, I am wary of using it as my guiding light. I reckon that the 25% growth could last 5 years (Stage 1), which is followed by another 5 year period of slightly declining growth (Stage 2) which then gives way to lower stable growth (Stage 3) equivalent to the risk free rate of 3% (yield on the US 10 year T Bond) in perpetuity

 

C. Fact: Operating Margin 

• The Adjusted Operating Margin Pre-Tax estimated in Exhibit – 3 above is 10.92%. Typically, Pre Tax Operating Margins in mature software companies is around 20%

C. Story:  I know it would be to broad to assume a target pre-tax operating margin of 20%. The firm is currently at 10.92% (after making adjustments) and hence it seems reasonable to make 20% as a targeted margin. I go on to make this parameter configurable towards the end to see what kind of effect it has on my valuation

 

D. Fact and Story: Re-investments

• This is perhaps the most important and most difficult parameter to forecast specially when we do not have a lot of financial history available. There are multiple ways to estimate re-investments
  1. Top-down: We need to forecast the invested capital turns or the sales to capital ratio. Re-investment is sales to capital multiple times the incremental revenue
  2. Bottom-up: Forecast the Net CapEx (i.e. CapEx – Dep) and Working Capital changes. The sum is the re-investment.

Bottom-up can be put to use when there is some financial history available, but for growth firms I prefer the top-down method, which essentially requires us to have a view of the capital nature (intensive/light/efficient) of the business and then use the corresponding industry benchmark sales to capital ratios depending upon the nature. Moreover, we could also use the sales to capital ratio of the current base year and extrapolate it to future years (Nothing is incorrect! it all depends on our view of the company)

Sales to Capital ratio in the current base year = Sales / (Book Value of debt + Present Value of Future Lease commitments + Equity + Value of R&D asset (current + past un-amortized) – Cash equivalents)

Sales to Capital in current year= $228 mn / ($33.88 mn + $3.37 mn + – $30.60 mn + $77.54 mn) = 4.31

This ratio translates to a close to minimal capital need business as per industry benchmark. But, I reckon extrapolating just one year’s ratio to generalize the nature of the business and take a call on future re-investment needs is a stretch!

Prof. Aswath Damodaran gives the following benchmark ratios depending upon the capital nature –

Minimal capital needs, no acquisitions (10.00)

Minimal capital needs, small acquisitions (5.00)

Service company median (3.00)

Technology company median (2.50)

US company median (2.00)

Capital intensive company median (1.50)

In my valuation, I have used Technology company median (2.50) for Stage 1 and then used US company median (2.00) for Stage 2. I have done so since I reckon the company is neither capital intensive nor capital light. I do not claim to have any certitude about these numbers. The reduced sales to capital ratio in Stage 2 implies increased re-investments as the company transitions to stable growth

For Stage 3, we do not have to forecast this ratio.

During stable growth, Re-investment Rate = Growth Rate / ROIC

ROIC again is tricky. The adjusted base year ROIC is calculated in Exhibit – 4. Adjusted ROIC base year = 32.96%

Exhibit – 4

During stable growth, I have taken a 75th percentile ROIC benchmark, which is 20%. Transitioning from the current adjusted ROIC of 32.96% to 20% in stable growth seems reasonable (again I do not claim to have any certitude about these numbers)

 

E. Cost of Capital

I have used the cost of capital from the S-1 prospectus directly which is 7.2 %

 

The above **Facts->Stories->Numbers (well, from A through to D) helped me forecast the following main parameters we need for this valuation –

**I know we had limited factual data.

1. Revenue Growth (during high growth, transitioning and stable growth period)
2. Periods of Growth
3. Operating Margin (during stability)
4. Re-investment
5. Cost of Capital

On plugging these parameters into the valuation, I get a per fair share value which is very close to the IPO share issue price of $15. On reducing the Sales to Capital ratio to 2 for both Stage 1 & 2 and also toning down my ROIC expectations to 12.5% (which is the US industry median), I get a share value of $13.1 (which again is not too far off from the IPO share issue price). However, post the public issue the stock has become overpriced.  

Exhibit – 5: Present Value of Forecast(ed) Future Cash Flows. Cells in Orange are configurable