Freshworks Inc. (FRSH) Earnings Call Transcript & Summary

Thanks for being here today. I'm Ryan MacWilliams, mid-cap research analyst, here at Barclays. With me today from FreshWorks is Tyler Sloat, CFO. For those who are in the room, you heard me, I guess, talk about the Eagles to start, but we won't be taking questions directly. So if you do have questions, please e-mail me at [email protected], we get those questions in. Tyler, kind of high level besides how great my [indiscernible] Eagles are doing, which looks pretty good. We can definitely talk for 30 minutes about that. What should we take away from the most recent quarter? I think investors were impressed how Freshworks held up kind of given this current environment. What were the things that stood out for you?

Yes. We were really pleased with the quarter, actually. We've been talking since the end of Q1 that we were seeing different things happening in the market. I think pressure in some SMB side that Europe, we expected to see some pressure. But -- in general, what we said in the quarter is everything happened kind of the way we thought it was. New business is actually strong, which was good. And what we said is it's not like we crushed new business, but it actually was good. Our churn rates remained stable and churn for us includes contraction, which just demonstrates the resilience of the products and what they mean for the customers. Net dollar attention went down, but we expected it to do that because the expansion motion is seeing pressure, and we actually expect that to continue for a little bit. Our expansion motion is driven by agent addition by far, by agent addition. And as it just makes sense, right, as companies are not hiring people, you're not adding agents. But again, we kind of expected that to happen. New business was a good sign. On the flip side, operationally and efficiency wise, I would say we did really well on the bottom line. And we were able to take the beat that we had on the operating loss side and roll that through and then say we're going to do even better for the year. And then we're doing everything we said we're going to do in terms of our use of capital. And we said we'll be cash flow positive in Q4. We came into the year saying we're going to burn about $25 million. We've reduced that to say it's going to be high teens. And then we said we'd be cash flow positive thereafter. And so these are all positive things in the quarter.

Excellent. And just take a brief step back for investors that might be newer to Freshworks. Remind us talking about some of the unique aspects of your go-to-market model and your platform that can make you better suited for the care environment.

Sure. First thing is we have 3 main products. We start with Freshdesk, which is customer support, then moved over to ITSM and as our Freshservice product, and most recently, our Freshsales and marketing products. All of the products kind of have a 3-sided go-to-market motion. We -- the DNA the company was servicing SMBs from the very beginning, it's all fed by inbound. So 100% inbound being our SMB base, which is a 250 employee and below base. Our Freshservice product doesn't play as much in the SMB, but it just makes sense. Companies of SMB side don't need an internal IT solution often, but we do have SMB customers there. The second piece of the motion is outbound. And that outbound motion is really fueled by NGO sales representation. It looks more like enterprise sales, but they tend to be more inside sales of just NGO, mainly North America and Europe with some in Asia as well. And then we have a partner motion that really supplements both the inbound and the outbound, but really is playing in geographies that we don't have local presence that we utilize partners for local language and things like that. That inbound motion is feeding the Desk and Freshsales and marketer products primarily and Desk plays all the way from the bottom all the way to the top. In fact, our largest customers tend to be Desk customers. And again, that outbound motion is really -- Freshservice is what plays mainly in that mid-market enterprise space along with Desk.

And can you talk about like the durability of that self-service motion? Like is it just you put dollars in and you get increasing efficiency on the self-service side like how much control do you have over that into a tougher macro?

Yes, indolent is driven by organic and paid search. And so we will -- we're constantly looking at how much we're putting into the digital marketing kind of spend bucket and seeing where we get the biggest returns. We can change it by product, we can change it by geography. And we have an entire team dedicated to try to drive efficiencies there. And so we can track it from website hits to trial starts to trial conversions and kind of watch it all the way through. And as auction rates go up and down, we will adjust, right? We don't want to just throw money, good money after bad there. The other thing is that organic search can play a big role and then you can tweak that through a lot of your web presence and whatnot. We're very focused on that as well.

I try to track as much as I can, those auction rates. Have you seen any changes there yet? Or are you may be surprised you haven't really moved on?

I don't know of any major change. We did in COVID see things dramatically change there, which I think was good for us. right now, I haven't really seen it, but I wouldn't be surprised that actually changes.

Yes, next year. Yes, I've been looking to it. And I'm surprised it's held in, but I guess there's a lot of competition for these seats just because how long people stay with Freshworks. You talked about the multipronged approach and your go-to-market. Just from the macro side, any place that's like maybe overly represent itself given some of these pressures or maybe you surprised that it held up as well as it has.

Well, I think in general, what we said is churn has held up, which I think was great. I mean -- because that includes contraction. And so that is a very positive sign. In Q3, we said new business was actually good. And I won't say it was a surprise because we actually -- we can thrive in lets call it tougher macroeconomic situations because one of our value prop is that we can provide great software at great cost. The last thing is Freshservice as a product just continues to do really, really well. And part of it is because it's just a great product. The other is that it's competitively situated in a great space, right, where we have a competitor at the very high end. We have a lot of companies who are still using legacy on-premise stuff. And then some competitors at the very low end, we are the #1 SaaS player in that mid-market in the enterprise space.

Yes, I definitely want to get into your ITSM market opportunity, but one of the players that you get asked a lot about, I used to cover here at Barclays with Zendesk. They recently gone through with the acquisition. Anything you're seeing from their side from a competitive standpoint or if they get more aggressive on pricing? Or just in general, I'd love to kind of hear where you think Freshworks stands versus them to that?

Yes. I think -- so Zendesk is still there, right? What we've said is, look, if your salesperson working for Zendesk, you're going to make your livelihood by selling, so you're out there trying to sell. We are very comfortable in greenfield opportunities competing with Zendesk and have been for quite some time. I can't say anecdotally, I think they're being very aggressive on price when they're the incumbent to try to keep that. And we are seeing customers reach out to us as they're coming up for renewal ahead of time with engagement. And so that could be more of a stocking horse strategy, right, to just get their own price reduced, but we are starting to see some of those deals come over. It's hard to see now because we've always had switches over. And so we'll have to wait to see if it's actually going to be a bigger trend.

You guys were competing long before the recent deal activity. Just for investors in our history, can you just talk about the areas of your business where you compete more directly with Zendesk and what market segment?

So Freshdesk product is where it goes head-to-head with Zendesk. I think it has to do probably more with the -- the customers are still focused on more traditional support, which is e-mail and telephony. What we've been talking about for a couple of years now is that there's a whole new age of company coming up that has a different customer base that doesn't really engage with them on traditional support. It's going to be all about conversational messaging. And we've been innovating on that for years now. Really led with our chat product and then a lot of kind of AI and bot stuff built into chat. And when we talk about multiproduct adoption, this kind of ticked up. The biggest driver of that is chat being added to traditional support, which is kind of a proof point that this is happening. And so in that space, there's a bunch of point players. And in that area, we feel like we're very strong.

If people follow my research, you know, I talked about it all the time, as to be a customer service agent, and now folks just go right to chat. That's the easiest way. And that has been a true differentiator between different self-service products is can you engage over that medium and you definitely see an example of better solutions than others. You probably know that from your own consumer experience. Just since I got the CFO on stage, investors are trying to get more help with their model for next year. And you talked about pressures on that retention, which isn't exclusive to Freshworks, right, that's kind of across the business. But I guess, how can investors get comfortable given some of those seat-based pressures how to think about your growth algorithm?

Yes. I don't -- so nothing's changed from what we said in our Q3 call. We're not giving any guidance for next year. But we haven't. I understand that folks need up there in our models. What we said on the call is like, look, in absence of any other information, use what we said for Q4 and run that through it. On the expansion motion, I do expect that to see pressure for a while. And I don't know if that's the first half of the year or not, I don't have a kind of a magic lens there, but we're prepared for it, right? And we're going to build our operating model around that. And -- we're also seeing new business as we said in Q3 was strong. And I think we've got to take advantage of opportunities to grow through new business as much as possible as well.

I think that makes sense, just what we're seeing in the broader SaaS environment. In last quarter earnings, you said your multiproduct sale has been doing pretty well and is growing. Any changes there as we went through this, like macro?

No, there any changes. The -- our multiproduct adoption is really driven by chat being added or omnichannel being added to Desk still the big driver of multiproduct adoption. I think over time, we would expect to see more of our fresh sales and marketer combination through to support. It's still too early to really have that being influenced. There's no natural cross-sell between Desk and Service, even though we have a lot of customers who are using both products, but it tends to be more of a trusted vendor kind of relationship, meaning that we prove success with one, and then we naturally can go get introduced to the other division. But I don't expect anything to change dramatically.

I'd like to tell you talk about just having that common data model to really lead to like an aha moment as you add different products and definitely makes like the multiproduct story makes sense. Just given your cost advantages on the R&D side, right, as we enter the environment that we continually talk about, how do you think about potential cost efficiencies that you can drive your Freshworks? Like what are you guys thinking about as you budget for next year?

We're spending, let's call it, low 20s is really like 21%, 22% on a non-GAAP basis on R&D. So it's a little bit higher than some of our peer sets. And I think over time, that does need to come down a little bit, but not dramatically because I do think it's one of our -- our competitive advantage is that we have access to a highly technical talent pool in India that allows us to innovate and create -- have more products than our competitive set for the size of company that we are. And we should take advantage of that, and we plan to. I don't plan to drive that cost down dramatically. Over time, I do think there are areas of efficiency that we can drive through the operating model. Our gross margin is already really healthy. We're at low 80s. And I think that's strong and won't get dramatically better. G&A is more of an economy of scale thing. We absorbed a lot of public company costs this year. We'll drive that to kind of high single digits. That takes a while, though, as you absorb stuff. So really, it's about sales and marketing. And a lot of our focus is on the dollars that we put into our go-to-market machine, what are we getting for those and making sure that's efficient as possible.

Excellent. And with Dennis Woodside coming as President, he's a Philly guy. So he probably -- he had the transcript and he loves the Birds conversation to start. But how should we think about what he can add to the team? And what is he focused on in his early days of Freshworks?

Yes. I think there's a couple of things. First is the partnership between him and Krish, our CEO. What the addition of dentist does it frees up a lot of time for [ G ] to focus on vision on product, right, and product strategy and really working more with the product and engineering teams. So that's the first thing. Second is, Dennis is kind of a proven operator and execution-focused mindset. Maybe it's a Philly thing, I don't know, and a lot of background on the go-to-market side. So he is definitely spending the majority of his time right now focused on that and focused on next year and any tweaks that we're going to be making to the model and things like that. And it just -- it also provides another lens. And if you listen to the call, not just a thesis but really a strategy that we can be doing bigger deals. And -- we're not talking about big enterprise million-dollar deals. We're just talking about more of the $100,000, $200,000, $300,000 deals and it's because we already have those customers. We very prove that we can be very successful with that customer base. But I can't say we've been excellent at that outbound sales motion, and he can bring a lot of rigor to that he's got a lot of history there, and we can have a lot of focus there. So that is one thing we're focused on.

Yes. Building on the channel ecosystem, which you guys really highlighted, you just talked about maybe some like self-help execution issues in EMEA earlier this year. Is that another area of focus from just kind of building out the [indiscernible]?

Yes. In retrospect, I don't even know if we should say that because in Q1, we said, hey, we had some deals that we think were execution because -- they didn't get pushed, right? We lost them, we look at them, we probably -- and then in Q2, we actually flipped it. We actually had a good quarter and we thought we fixed a lot of those things. But in general, I guess, yes, I mean, the answer is that is all about that field motion and that outbound motion focusing on customers like that and the maturity of that motion. And I think there's is for improvement there.

And then just with your -- while we're on the topic, your international exposure, right, like 40 U.S., 40 Europe, 20 rest of the world. Numbers right. I'm not going to the decimal points yet. But when it comes to how we think about that next year, I guess people are surprised that maybe you did so well in International last quarter. I guess any morning signs or anything to call out.

So that's kind of -- those numbers represent our entire kind of ARR base, not necessarily the quarterly numbers. The -- I think what we've seen is the pressures on FX. Because of that 40% in EMEA, it's not 40% in GBP and euro. It's actually a little bit less than that because we do sell in USD to some customers over there, but it is higher than a lot of our peer set, which has that pressure on currency, right? So we've been giving a lot of constant currency numbers. If the dollar weakens against the pound and euro next year, that's going to be a benefit from a top line perspective. We do get a little bit of a benefit now because of INR has weakened a little bit from the dollar. And so on the expense side, we are a little bit expense heavy in INR. But the expense piece, I think we have pretty good control of the revenue piece, we just can't -- we don't really have a control.

And just because it's kind of a sign of the times, more questions about stock-based comp, SBC is pre sales than ever. Have you guys kind of rethought about how you're approaching that light item or changes next year.

I can't say we've rethought about it. We've always thought about it. We've always had a focus on it. What we said is, hey, we're going to have dilution in like that 3% to 5% range. And I think of it -- I think dilution is different than stock-based comp because stock-based comp is based on the price that 3% to 5% could be really higher, it could be a lot lower, right? Now yes, we are very focused on it. And we do know that it's important. We're going to do a 3-step process first. The first step is we're going to get the sustainable free cash flow positive. And we said Q4 and all of next year, and let's get sustainable. Then non-GAAP operating profit will follow. And it follows typically like a year later, right, rough numbers when you just look at peer sets and how you hit it. And then GAAP operating profit is going to be after that, and we have to work on communicating to the investor base on what the strategy is there. We are very focused on it. The Board is very focused on it. What I can say, though, is it's not like we can influence stock-based comp right now. We can't make it go away, right? You are stuck with what you have. A lot of what we have is based on the grants that were made around the time of going public, and we've got to let those amortize out. And so yes, it is a focus.

And just kind of while we're talking about operational efficiency, would you be comfortable just reminding investors kind of like the guidance you gave around free cash flow positive and so you're going to get there.

Yes. We started the year saying we're going to burn like 25. We have been reducing that. We said we're going to end the year at kind of high teens. We said we'll be free cash flow positive in Q4. And we said for all of next year as well, there's going to be quarterly nuances next year because there's timing of different things that happen. But I don't want to have free cash flow positive only because we hit it in Q4 and made up for the rest of the year, like we do want it to be -- looks like it's more of the operating model that we're moving towards. So that is the goal.

And just from your current capital position, really strong balance sheet, over $1 billion cash and cash equivalents. Like, I guess, any areas to take advantage there? Or I guess like how can you use it to your advantage next year?

Yes. I mean, yes, we are very strong financially. We're going to get to a point we're not burning any free cash flow. But we have $1.2 billion in the bank, and we don't have any debt. So that feels good. We have been using some of the capital this year, about $150 million to do net settles on RCs. And it's not a buyback, but it is essentially paying the taxes for those shares. Off the balance sheet, and those shares actually never get entered into market. So it kind of technically operates like that. And I think we're going to continue to do that, I think it's a good use of capital. Secondarily, we've always said we've been open to M&A, right? And we've done them in the past, and we will continue to look at them at deals. They would tend to be smaller tuck-ins for technology or teams. And just over the last couple of years, things are too expensive, right? And -- but I think that's changing. And so I think there's going to be opportunity to do stuff going forward. So nothing planned, but I think there will be opportunities there.

And it's tempting now to kind of put the foot down on the accelerator and maybe capture some engineering talent that you couldn't get before, right? That maybe is coming up. But like how do you think you're situated from a headcount perspective at this point?

Yes. I think -- well, I think we're doing opposite actually, like we've had the advantage we've been hiring really rapidly. And we have slowed that down, right? Because I do think we have a lot of people on what we should digest what we have and make sure we're really disciplined about that. We are still hiring across the board, specifically hiring quota-bearing reps. And we're hiring across our functions, but we are trying to drive a lot of discipline into the organization to hire the right people in the right places and let's be smart about it.

And I promise we circle back to it on the ITSM market. You talked about how Freshservice was largest contributor to ARR growth last quarter. I guess what's exciting about that market opportunity, how can I bring into larger customers?

Yes. It's actually the last 2 quarters has been the biggest contributor. And -- number one, it's a great product. It's just a fantastic product, and customers love it. It has great characteristics all across the board. It's very resilient. I would argue, kind of enterprise-grade churn rates already. Competitively, ServiceNow is a great company. They're playing very high up, right? And we can demonstrate that we can provide a customer a modern technology stack and everything they need without the cost that is associated with ServiceNow. I can't do everything they do. We're not claiming we can, but most companies don't actually want or need everything. In that market, it's shocking how much legacy is still out there and really on-premise legacy is a lot of it. And that's actually really expensive to maintain as well. And so as those go through refresh cycles of even physical products or what you're running on your service, we can provide you a great alternative. We can get companies up and running very quickly, too. So we can demonstrate ROI very, very fast. And we will continue to push on that because I think it's a huge market opportunity. The other thing we're really excited about is we announced Freshservice for Teams, which is purposeful ESM application, where we already have a lot of customers using Freshservice for different functions outside of IT. And it's a realization that you actually need purposeful workflows and you also need other features like security and things like that. And so that's what we built and launched, so excited about that.

And just, what market segment that attacks, am I thinking like 50 to 250 or 50 to 500?

The Team's part? Or no, so Freshservices playing squarely in kind of that mid-market, low enterprise, let's call it, even all the way up to like 10,000 employee businesses. So some very large company names in there that are using Fresh -- not Freshservice, right? Freshworks for Teams, what we're seeing there is that there's great applications even for companies who are using our competitors where it might be way too expensive for them to roll this out with an HR group or a finance group or a legal group. And so you can put us in as a supplement to whatever -- if you're using ServiceNow say.

Excellent. And just have received questions on the change in Chief Revenue Officer, right? That's something that is kind of a sticking point for investors with software companies globally. Like anything to call out there or anything?

No, not really. I mean, I think it's Dennis bottom on board has really focused a lot of his time on go-to-market motion. So not a big surprise changes there, but it's actually been a very seamless kind of transition for Patty to come over, who Patty was our Chief Customer Officer, and he's now our Chief Revenue Officer. Patty was running all of customer success, which is a large organization, all of support and all of customer onboarding. He had already been engaged with the field a ton with customers a ton. And so Dennis and him are partnering a lot with Stacy, our CMO, on what the plans are for next year.

And we think a lot about compressure that companies face during COVID, right? I know we saw a digital economy explosion -- significant demand coming out of 2020. But are there any corollaries to all with the market opportunity you see ahead versus what happened in 2020?

COVID, I don't know, we'll have to wait to see. A couple of things. One is it's not like as dramatic of an impact where we issued a ton of credit out in COVID. We actually took this stands to be customer-friendly. If anybody asked or just asked for anything, we just automatically give it. We're not seeing that kind of stuff. We also saw a whole customer segments kind of disappearing in COVID, right? You have your hospitality and travel. We have a lot of customers who just don't exist anymore. That being said, on the flip side, we also saw upside from customers migrating off of very expensive solutions on to us. We could do it rapidly and save them a lot of money. We are going to see parts of that. We already are seeing some of that. So hopefully get that kind of benefit without the whole customer segment going away. It's really just the expansion motion, it's really just how long is that going to last.

And I guess, at this point, you're not seeing the same level like downgrade activity or churn or things like that?

Look, our term is stable in Q3. And churn includes contraction for us, right? And so the fact that we have contraction every quarter across customers, but the fact that it's stable, inclusive of that just speaks to the resiliency of the products with the customers.

And just as you start to -- and we're kind of running out of time here. But just as you start to move upmarket, that adds more billings and changes to your model, like anything we should think about there like longer contract cycle potentially? Or is that a little more down the road?

Yes. It's down road. We are not -- like we're not focused on doing multiyear deals. It's not really our motion. We had already seen a shift. We've got like 60% of our business is in that mid-market and enterprise space. The majority of that is annual deals and annual deals are annually paid upfront. I don't see a dramatic shift in that. I expect that to happen.

That wraps up for me, guys. It's been a pleasure. Really great to have you at Barclays TMT Conference. Second fireside here at Barclays. So I appreciate it. I'll see you next year.

Awesome.