Thinking About Fiverr And Upwork Pair Trade, Think Kahneman

We looked at Fiverr International Ltd. (NASDAQ: FVRR) and Upwork Inc. (NASDAQ: UPWK) as a pair trade, i.e. going Long Upwork and Shorting Fiverr, but Daniel Kahneman inspired ‘Type 2’ thinking helped us conclude that it isn’t as good a trade as a first look at the two stocks and their respective valuations may want us to believe, especially if the market continues to favor growth.

Why did we bother?

 Next Yr. PEP/ Sales Current Yr.Sales 2019Enterprise Value ($M)EV/ next yr. sales
Fiverr 210.3 25 $107 $4,220 17
Upwork Loss 5 $301 $1,730 4

Like many investors, we looked at the apparent valuation gap between the two businesses, and given the premium enjoyed by Fiverr International right now, it was easy to conclude that reversal to the mean will lead to the closure of this gap between the two companies. Indeed, Upwork was included in our most recent weekly list of top ideas for the week.

After all, both companies, running talent marketplaces, compete in the same field and bound to enjoy the strong industry tailwinds underway, be it the rise in remote working, businesses shying away from permanent hires, the sudden spurt in demand for workers in selective categories like technologists required to take any venture online, games developers, etc., combined with limitations on full-time hiring, financial or physical.

Think Kahneman

Most readers may already know that Daniel Kahneman in Thinking, Fast And Slow, a book that we believe should be made compulsory reading for anyone opening a trading account, has talked about Type 1 and Type 2 thinking.

Briefly, Type 1 thinking is fast, easy, susceptible to bias, and one which most of us fall for easily, whereas Type 2 thinking is slow and resistant to cognitive biases, but requires effort on our part to study deeper.

It is this Type 2 thinking about this pair trade that is making us wary of what looks like an easy play on valuation arbitrage.

Similar, but not so similar

Yes, both of them serve as a middleman to match businesses and freelancers, but that is where much of the similarities end, at least for investors, since there is no dearth of platforms offering such services and merely comparing the cosmetic functionalities of the two platforms wouldn’t be the best use of time for readers here.

Growth strategy, approach to market, and execution is where the difference between the two matters and easily visible.

Upwork

As the chart above shows, Upwork has a significantly larger revenue base and for most online businesses scale offers an advantage, i.e. brand, margins ability to spend more on development, marketing, etc., things that lead to better topline growth and profitability. A moat that attracts better trading multiple.

But no such advantage here. Even though Covid-19 is leading to a historic increase in demand for freelance and remote workers, the business barely grew at 19% last quarter and the guidance for the current quarter largely disappointed the Street.

Besides low revenue growth rate, conversion and client retention rates also weakened. There is a new chief financial officer on board and the management is worried that business may deteriorate if the economy doesn’t come back quickly.

Yes, performance is quite a contrast with Fiverr. Why? One big reason is the company’s focus on larger enterprise customers and higher-value work, just when the major growth is coming from small-medium businesses needing help to take their businesses online or gaming companies in need of additional help quickly.  

Instead of moving towards small-medium businesses, Upwork seems to be doubling down on the strategy, with talent grant programs and partnerships like the one with Citrix Systems. Besides increasing the business concentration risk, the strategy may not do much to improve the weak take rates.

Fiverr

On the other spectrum is Fiverr. Rather than worried about the client’s health, the company is experiencing renewed growth from old customers. Instead of weak guidance, revenue came in 30% higher than the high-end of the guidance, added a record number of buyers on the platform, and saw the e-commerce category tripling in size and gaming growing by 9X.

Why? One big reason is instead of relying on a few big clients, the company has focused on small-medium business, expanding its customer base and serving the seller side services they require.

The company has pushed ahead on localizing the platform with five non-English websites and going for international expansion now.  Streamlined internal systems and platform with things like catalog expansion, easing seller onboarding process, and adding more categories, the result is visible in improving leading indicators like increasing the number of buyers and sellers on the platform.

Indeed, some of the changes underway have the potential to significantly expand the scope of services and take the platform to the next level. On the buyer side, the company is adding tools for teams within a business to collaborate, launched Fiverr Business, and expanding the category of services. Changes that can help the company move upstream to cater to enterprise customers.

On the seller side, better tools to interact with customers, adding back-office tools for freelancers to manage contracting and invoicing, learning tools, and advertising tools to help freelancers market are some of the things that can further help expand the seller base.

Yes, better execution leads to better numbers

Understanding these strategic differences between the two businesses matter little if the benefits don’t boil down to numbers. Yes, the difference in numbers is equally big.

Revenue growth rate    
     
 201720182019Q2 2020
Fiverr 45%42%81%
Upwork23%25%19%19%

Fiverr is not just growing fast but also a significantly big beneficiary of the recent surge in demand.

Gross profit    
     
As % of revenue201720182019Q2 2020
Fiverr74%79%79%83%
Upwork68%68%71%71%
Excludes stock-based compensation

Even with a small revenue base, Fiverr’s gross margins are better as well as growing fast compared to flat margins for Upwork, even with growing topline, highlighting a lack of margin leverage for the company.

Research and development    
     
As % of revenue201720182019Q2 2020
Fiverr30%34%29%20%
Upwork22%21%19%20%
Excludes stock-based compensation

Both companies are spending almost equal share of revenues on research and even though Upwork is spending more in dollar terms, benefits of this higher spend on revenue growth are not visible yet.

General and administration    
     
As % of revenue201720182019Q2 2020
Fiverr16%15%15%10%
Upwork17%17%18%16%
Excludes stock-based compensation

Somewhat similar leverage is visible in general and administrative expenses as well.

Take rate    
     
 201720182019Q2 2020
Fiverr24%26%27%27%
Upwork13%13%13%14%

More importantly, Take Rate, the company’s share of service revenue transacted on its marketplace, for Fiverr is almost double that of Upwork. Every new buyer, seller, and transaction are disproportionately more profitable for Fiverr.

Conclusion

Investors have to worry about customers of business but customers have no such obligation. So a stock like Fiverr may be expensive but that doesn’t mean that the underlying business will lose momentum anytime soon.

The glass half full versus glass half empty. Fiverr is benefiting from market dislocations associated with the lockdown and weak economy, which Upwork is worried about delays in an economic comeback.

Is Fiverr relatively expensive? Yes, but that is rarely a good reason to go short a technology stock enjoying extremely strong fundamentals and the gap may not close as long as the performance gap is even wider than the valuation gap.

DISCLOSURE: Before writing a note, we usually ask (via Twitter and Stocktwits) for things readers would like us to cover in the note, please do share your views for our next note. This is purely an academic exercise for our internal use and you should NOT invest based on this note.

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