Freshworks Inc. (FRSH) Earnings Call Transcript & Summary

Thanks for coming to the 2023 UBS tech conference. It's great to see all of you, and I'm very excited for this session that we have with Tyler Sloat, who is the CFO of Freshworks. So Tyler, thanks so much for joining.

Taylor. Thanks for having us.

Yes, of course. Before we begin, I just want to let anyone know if you have a question, which we'll try to address them at the end, you can submit your questions through the app, and then we'll, like I said, get to some of those at the end.

So maybe to start off, Tyler, I'd love to ask you, so this past earnings season, I think you had a lot of software companies with SMB exposure, where you had some that skated along like things were fine, you had others that talked about incremental weakness. I think you guys were more in the camp of saying things feel more stable. But I'd love maybe for you to elaborate more in terms of what you guys are seeing in the macro environment as it relates to SMBs and then if there's any demand tailwinds that you would point to that might be a reason why you guys might be weathering the storm better than others.

Yes. So I guess I'll back up. SMB for us is 250 employee businesses and below. About 40% of our business now is SMB. So we've kind of shifted a little bit over time. Q3 kind of came through as we expected. So there was no real big surprise. I think the nuance is that we had started talking about macro pressures at the end of Q1 2022. Really -- where our expansion motion was again hit a little bit. And that's persisted over time. And I think what we did is we just adjusted, right? We're -- tried to figure out what growth is going to be without agent expansion in particular, and SMBs did get hit more than others, and figured out how are we going to grow with our customer base outside of that. But we didn't see any incremental pressure. And like I said, Q3 kind of came in as we expected.

Yes. That's helpful. And then maybe let's dive down into like the different product types. So obviously, you have customer service, ITSM, sales and marketing. So when you look at like those 3, how would you characterize the like the health of like each of those businesses individually, right, and to the extent there were any changes within the macro within each of those?

So our CS or customer service product, it's still our largest product line, but definitely the one that's been impacted by the most by -- from that expansion motion kind of seeing pressure over the last 1.5 years. And that market in general is becoming a little bit more fragmented. That being said, we've done a lot to kind of keep up with what the new trends are there. And we've launched at the end of Q2 our customer service suite that's already starting to see some good traction there. And we have a lot of other things that we're focused on there, specifically some of our AI initiatives. Freshservice, which is our ITSM solution, has been doing really, really well, and that continues to be the driver of growth for the business. And in that space, we are just positioned really in a good spot, where you have ServiceNow at the very high end, you've got a lot of legacy players that a lot of it is still on-premise, and then you have kind of Jira Service Management, [indiscernible], these guys servicing really smaller companies. And we are kind of regarded as the #1 SaaS alternative underneath ServiceNow. Our Freshsales and Freshmarketer products broadly under CRM category is -- it's still new, and they're starting to see some good traction specifically for SMBs and for B2C businesses that we can really serve well and provide a great solution kind of from lead all the way through to support, but that one still needs to have an injection of growth, and that's what we're focused on right now.

Got it. That's really helpful. And then maybe on the ITSM side in particular, because I think that's the area that you guys have sounded really upbeat on these last few quarters, and I know you've made changes on the go-to-market side to move more market there. But can you maybe talk about the demand tailwinds that you guys are seeing on that side? So are there any product cycles that are occurring within the incumbent space? Why now, right, might some of these mid-market companies be looking at these solutions that they hadn't had in incumbent before? Like what are some of the tailwinds? Is it more self-driven, where now you guys are making a bigger go-to-market push there? Or is there actually some underlying demand trends too?

Yes. I think we're definitely making a better -- a more go-to-market push, and we built out this field presence without -- throughout North America, Europe and parts of Asia. And over -- I'd say, over the last year, 1.5 years, those individuals have learned how to sell that product really well. But I think it's chicken and egg. Is it because the demand is there, or because they actually like the product and go sell it? I think it serves itself. The thing that's happening is that space has just been kind of underserved, that space being kind of high end of SMB, which is kind of the employee base that's around 250 to 200 all the way through the low end of enterprise, which is kind of like the 7,000-person company. Traditionally been served by a bunch of legacy products that are kind of old tech and now moving -- like they're coming out with cloud versions. And they're forcing their customer base to shift, right? They're saying, you got to go migrate to the cloud. And whenever you do that to a customer, they're going to go look at alternatives. We are a great alternative, priced really to provide value but also with tech that is regarded as it is really, really good. And so I think just because of that, yes, it's positioned really, really well in the market.

Yes, that's interesting. It makes a lot of sense. Maybe shifting then to the other side on the customer service side. So you mentioned you guys are still seeing a lot of pressure on the seat side of things. Now if we look at your NRR, that fell 1 point to 106%, but it sounds like your messaging is that we could start to see like some stabilization in that metric. So on the CS side, what gives you guys comfort in that stabilization? Like what are you seeing to say, hey, this is kind of where we're getting to the bottom? Is it that you've gotten through a chunk of the renewals where you've already seen that optimization activity? Maybe you could just elaborate a little bit more on that.

Sure. So net dollar retention for the whole company, 106% on a constant currency basis, we said it's going actually going to come to 105% in Q4. Coming into this year, I think we had called 105% for Q2. And we just have done better, specifically on churn. And that's the reason it's actually not hit 105% yet. We do -- based on what we see today, we do think 105% is going to be kind of the bottom. And obviously we'll update that if we see anything different. I don't think it's going to immediately rebound. I think it might remain stable there, and then we're figuring out how to grow. In customer support in general, yes, that's where agent expansion, which is -- agent addition was driving by far the large part of our expansion motion and expansion is very, very material for us. That one, it just kind of makes sense. As companies haven't been growing or if they've been downsizing, they reduce their agent counts. In that space, we've been trying to figure out, okay, how do we grow with our customer base outside of that. So a lot of focus on cross-selling of new products, which is now 25% of our customer base using more than one product, moving them up the edition chain and then new products like customer service suite that we've introduced. We'll see. I think it's a journey, right? We're going to have to go through this journey and figure out how to grow with our customer base, but I do think we've weathered the storm. Part of what gives us confidence that we've weathered, you mentioned, we've already been through renewal cycles. We don't sign big multilarge -- multiyear contracts. And so we've already renewed by far the majority of our customer base in all -- across all products. At the same time, downsell is included in churn. And we've been able to get churn to a company best. And in fact, last quarter was the company best we've ever had and reduce it from the low 20%s when we went public down to mid-teens now. And that feels good, right? It feels like -- and it includes the downsell, so it includes the pressure we've seen. So that, I think, is a testament to, okay, larger customers, annual deals now that customers are signing, but also the technology that we've actually been providing to the customers that is providing real value. So coming into next year, we have a bunch of initiatives that we've been working on. We've been talking about them now for about a year. We're starting to see some of them actually kind of take root, and we're optimistic that we have a chance to actually accelerate growth once these things actually start playing out.

Yes. That's actually a follow-up question on that. So when you think about like the difference between the growth drivers this year, right, versus next year, so you talked about like a lot of these initiatives that you've had in place that hopefully can become more tailwinds as we get into next year. How do we think about that in terms of the context of NRR? So if we start to see some stability, right, on optimizations and churn and things like that, where -- is it possible that you could start to see that metric trend up as some of these initiatives start to materialize? And maybe you can just go into more detail in terms of like the timing of when you think some of these initiatives could start to...

Yes. Our Investor Day in September, we -- first of all, we broke out all the products and kind of gave some of the revenue numbers around the product lines, which we haven't done before. And then outside of those sections, in my section we talked about, okay, there's 6 growth initiatives that are incremental to kind of what we said we were going to be able to do, which is $1 billion by 2026. And that $1 billion kind of -- if you run that out, it means you're around 20% growth every year. These initiatives, like one of the ones I just mentioned is cross-selling of additional products. So to be able to do that, you have to have prescriptive sales motions and train your field to be able to do that, but also you have to have the new products. So Freshservice for Business Teams is one of those products that we just launched in -- at the end of Q1 but really just started to kind of like get it out there. We now have -- it's roughly, I think, 20% to 25% of agents being purchased for Freshservice includes Freshservice for Business Teams as 25% of the agents. So we're starting to see traction on this. And these are things that are brand new to our customer base. Taking a little bit of price, which we have never done before because it's not really inherent in our DNA. We've actually been the opposite. We did a little bit of that in Freshservice this year. When I say it, we're literally doing like CPI increases, which we've never done before, and got zero pushback from customers. And so we'll continue that journey and looking at the other products that we can -- that we've been providing really a lot of value to customers for years I like to look at it as kind of reducing discounts as opposed to increasing prices, but not being a vendor who's going to go to their customers and increase price 50%, something like that, which happens to us, which is really frustrating. More like, hey, here's a 5% increment or 7%, which seems to be what everybody is doing, we just haven't been doing it. Our AI initiatives, I think they're really exciting. Just from a monetary perspective, I think we have to wait. If [ G ] or Dennis were up here, I think they'd say something different. I'd like to see that come through. The first one we have is Freddy Self Service, which is going to be reflected in bot usage, which we already see increased bot usage. And the way we're going to monetize that is through bot add-ons, as customers use the bots that they are entitled to, they have to buy more. And we'll start to see that, I think, starting at the beginning of the year. Freddy Copilot will be launched in Q1. That will be $29 per seat in addition to what they're already paying for the agent. Until we launch it and get it out there GA, we don't know, but we do have about 2,500 customers that are in beta right now and getting really good feedback on it. And then Freddy Insights, we don't have a launch date for that. I think it's going to be later in the year, and we have about 4,000 customers actually beta-ing that product. And so I look at these things, they are going to be incremental to our growth, stuff that we're not necessarily counting on but things that actually could provide real traction.

Awesome. I was going to ask some of these AI questions later, but because you mentioned them, let's just dive right into those. So I think you've talked about in your -- your outlook for your CY '26 outlook that you guys have that AI isn't a big contributor to that. So when we think about all these individual products that you mentioned, where are you seeing the most interest from customers today? How has feedback been around that? And as you look in the out years, like which of those products gets you the most excited or where you think can be the biggest opportunities?

Yes. I think the Freddy Self Service and Freddy Copilot are going to be the 2 things. So if you think about Freddy Self Service, it's all about allowing our customers' customers to quickly resolve any problems that they have, right, in self-service. So it's all going to be through bots and automation through those bots. The one thing I'm excited about there is that the hurdle to bot adoption historically has been building the bots, which has been really complex. And we've released now kind of our 2.0 bot builder, which allows our customers to actually, in our Investor Days, have bots building bots essentially, and being able to go out there and allow our customers to actually go use the technology a lot easier, as opposed to hiring services from us or building it themselves, I think is going to be really exciting. On Freddy Copilot, it's new, but that one -- 2 things. One, it's about allowing our customers to be -- the agents that they have be much more efficient in the transactions that actually do not go through self-service. And that one I think is going to be the one that's going to have the most impact overall to our customer base in how it allows them to service their customers potentially in a lower cost environment, whereas previously they might have had to hire people in North America if they're North American-based, or they could actually outsource that. But those agents now are going to have capabilities that they never had before. And I think that actually, not just for us but for other companies, could be really a big fundamental change for businesses in general. Freddy Insights is really about the administration of the entire business. That one I think is a little bit further out, and we'll see how that goes. But the first two are really, really exciting.

Yes. So on the chatbots in particular, so I think there's a really interesting opportunity for companies that serve SMB and mid-market companies where they might not have the in-house developer or resources in order to build these bots themselves. But I'd be curious how you guys see that playing out like when you look at the fact that you run on GPT, right, OpenAI, is it possible for these SMBs to go and build it themselves? What's the heavy lifting there? Do you guys see that as a risk? I'd love to dive into that a little bit deeper.

Yes. I mean, the phrase we use internally is like how do you deliver AI to the Fortune 5 million, as opposed to Fortune 500. That's what we're really focused on, like make it really easy for our customers who may not have the capabilities, and you're talking about in some cases a 50-person business, that really just want to do their business. But in order to have the access to all the new technologies, they'd have to hire that technical talent or spend a lot of money on it. To be able to actually inject that in the services that we're already providing them is really, really exciting. The thing is you have to make it really easy to use, which is what has been in our DNA from the very beginning. Like we built our software focused on the end user. Which means that it's truly built for the SMB. It has to have a great UI, has to have a great usability, has to have really fast go-to-market -- or time to value. We're doing that same thing with all the AI stuff that we're building. So that's why it's taken a little bit of time, right? You have to learn. You have to let the AI kind of models learn, but then also release it when it's really ready, and that's what we're doing with our customer base right now in all the beta programs we're doing. We'll see, right? That's the goal. We have to go out there, we have to release it, and then we have to actually start selling it, but it is exciting.

Awesome. And then on the monetization strategy. So you've had -- you announced a $29 co-pilot offering. You've had Microsoft do something similar. You've got Salesforce to do something similar, but you've had other SMB-focused companies that haven't yet put out their monetization strategy, or if they have, the early stages for some of the companies within my coverage is, okay, we'll first drive adoption, figure out monetization later, maybe they use it to drive the top of funnel, maybe they put it in the higher premium price SKUs. So is that at all, like those differences in monetization, like how do you guys view that? Like is that a risk at all, that someone could go to a competitor for a similar offering? Do you think it's just a matter of time before other SMBs start monetizing it? I'd love to get your thoughts there.

I'm not worried about the competitive dynamic there, meaning that what we are providing is built into the product. So to have something on the side, it would have to be deeply integrated, which I guess is possible. But it actually -- the model has to learn from the large language models, but also it's all about the data that we have internally that we're actually allowing our customers to utilize their own data, right, and enhance it essentially. And I think that's going to be the power there. In terms of the price, we've said $29, and that's based on, I'd say, more art than science on math that we've done internally on understanding what agent costs are for our customers, understanding what the potential efficiencies that they're going to gain, and then what we would want to get if we -- if there does result in a lower agent count for us. The goal here would be kind of a win-win-win. It's a win for the very end customer. They get resolutions to their problems and a better experience. It's a win for our customers because it -- reduced agent count at a human capital cost is going to be much less than the $29 that they're paying us, but also a win for us because that reduced agent count is going to be supplemented by the $29. So that is the absolute goal. We will learn as we go, right? We'll have to figure this out. The other thing that we've actually modeled out is cost, right? Because that's, I think, another big unknown, that companies are going into this, and it's all about the compute power. We are using Microsoft as our back end and then we use Amazon for our hosting. And we've made our estimates. We have great margin structure right now at 83%, 84%. And we don't think this is going to impact that, it might slightly, but there's a little nuance to the margin structure anyway. And so we will have to learn as we go. And I think there's -- I think it's going to be the same for all these companies, right? If anybody is coming out and saying they figured it all out, then I'd love to talk to them.

Maybe when we think about the adoption ramp of this, I know you mentioned a little bit of this earlier. I've mentioned earlier different products and when you think that they could start to be bigger, bigger drivers. But in terms of what we're seeing more near term, like do you think that this could start to be a material driver of growth like within 2024, or is this probably a few years out? I know you guys...

Specifically the AI stuff or other stuff...?

The AI stuff. Yes. So I would imagine, because you guys have had things like chatbots, right, for a while, so this isn't necessarily new. So has a lot of this talk around generative AI been a catalyst for conversations with Freshchat and maybe your new customer service offering? Like could those actually be maybe more material drivers whereas the other stuff might take a little bit longer.

Yes. So Freddy self-service is the first one we put out. And we actually don't sell Freddy Self Service, it's kind of embedded within chat. We changed the pricing for chat at the end of Q2. So we lowered the entitlements that customers have in terms of how much chat sessions that they have, that they're entitled to when they buy the product. And then we increase the price for add-ons. That -- it will take some time to flow through as usage increases. I would love to be able to update our investor base in the middle of next year on what we're seeing. I don't think anything is going to happen before that. And hopefully we'll have some traction at that point in time that we could give some updates on -- even if it's usage as opposed to even monetization, right, because the monetization will come after. But that's my estimate for that one. On Copilot, if it launches in Q1, it will probably be towards the end of the year that we'd be talking about it.

Yes. Makes a lot of sense. Maybe shifting gears to another key topic, which is the CY '26 outlook that you have, so the $1 billion target. So I think in order to get there, you have to assume a CAGR of around 20%, which is where you guys are growing today. So one key question investors always ask is what gives you guys comfort? Macro's very uncertain. Things could change like that. So what are you seeing that's overpowering some of these macro headwinds that you're seeing that gives you confidence in that outlook?

Yes. You kind of asked earlier about just SMB pressure, have you seen it, have you weathered it? And I think we've been through a lot of it. That 20% which kind of gets you to the fiscal $26 billion, that is what we think is our baseline. And the 6 levers of growth that we kind of outlined on top of that would be incremental. We clearly have to execute to get there. But the reality is, like we're playing in 3 massive TAMs and have been able to create 3 products that could get to scale. And I think we're using reasonable growth rates specifically for our customer support product as well as our sales and marketing products. If we look at our investor presentation, the growth rates that we're assuming there are not incredible. And internally, nobody is really happy about 20% growth, right? they don't think that's super exciting. It is what we've been achieving right now, so we have to figure out how to go execute a little bit better. But I think it's more of an execution thing as a market thing. And the products are there, the products really work and the customers love them. And so it's about bringing those products to market. We have been seeing great traction at larger businesses, and we've earned the right to go engage with larger customers, our 50,000 and above customer number still growing healthily over 30%. And we're starting to see more annual deals, which is helping with churn, which continues to come down. And so these are all great things that we just got to continue to go execute on, and then the levers of growth on top of it, which I think we have opportunities there.

Yes. And if we break that down a little bit more, so if we look at the CS piece in particular, so the customer service piece, I think the CAGR assumes something in the high single digits versus the low to mid-teens that you guys are growing at today. So I'd love to dig into like what the assumptions are within that. Is part of that just, hey, this is a more mature market, right? Is that reflective of the high single digits? I know you don't have, it sounds like, AI and some of these other tailwinds really embedded into that, but in terms of where we stand today and looking at that growth rate, we'd love to understand the assumptions there. And if there is any assumptions related to generative AI, maybe displacing seats that you guys are trying to be conservative like -- what, would love to unpack that.

We didn't model in the last piece, right? We didn't model in how much would be taken over from, say, Copilot and whatnot. That market has gone through a lot of fragmentation, right? And some of the bigger players and our competitors have been taken out. The growth has been tough. Part of that has been driven by just new technologies that are out there, whether that new technology's -- which we've been talking about -- is like just purely conversational, moving away from traditional ticketing. And so our customer service suite, the product we launched at the end of Q2, it is a conversational product first, ticketing second, and that's what we kind of did with the rearchitecture of the product. We do think that that is the future. And we've been talking about omnichannel first and leading with conversational and we've been trying to stay ahead of what the trends are. At the same time, there's a bunch of point players that kind of popped up, a lot of them just doing bots or a lot of them just focusing on maybe some of the social aspects of support. We have now -- we feel like we've gotten to a point where we now have all of that stuff and we've put it all together under one platform. And so that's what we're leaning in on. The market is fragmented. I think you're going to see a bunch of that fragmentation -- I think some of the players that have been purely focused on bots are going to be in trouble now because now the new technologies, through specifically ChatGPT and everything else, is allowing other customers to participate in that, things like bot builders, you don't need an army to go build them. And so we'll see how it all plays out. We put out those numbers because that's what we see today, and we don't want to be super aggressive on assuming things are just going to come right back, but we do have opportunities to grow on top of that. The other thing that we assumed is that our agent addition expansion motion is going to kind of stay where it is, and it's not going to actually recover. Clearly, if companies start growing again, which I don't see happening in the near term, but I do think that's going to happen, that's just going to be on top of all of it.

Yes. That's really helpful. And then when we -- the other growth driver that is key here is that -- I think you guys are assuming that the greater than $50,000 in ARR net adds is going to be greater in the future than what we're seeing today. I know we talked earlier, you guys have implemented a lot on the go-to-market motion to push that. But what gives you guys confidence that you're going to continue to see that uptick. I think this last 3Q, it might have been a little bit lighter relative to what you saw in 1Q and 2Q. So maybe you can comment on that. Is that related to seasonality, a little bit of an anomaly? But would love to hear about the underlying transaction.

Yes. I'll answer the last part first. I think there is a little bit of seasonality, but then also FX played a role in that, that the dollar kind of lost some strength and then, as a result, that impacts that number a little bit. But we didn't -- I didn't see anything that was concerning on the greater than $50,000. We also laid out that the majority of our greater than $50,000 customers are customers that expand into it. So we still have customers that are expanding at a really healthy clip and growing into that customer base. I think the confidence that we have there is really across kind of a couple of things. Number one, it's going to be driven by Freshservice. And our growth rates are going to be driven by Freshservice, and we put that out in the numbers. And that -- by -- inherently on the company size that we're dealing with there, meaning that a true SMB doesn't need the Freshservice product, so we're really dealing in the mid-market. Those deals are going to tend to be a bit larger and that product is doing really, really well. Second, ARPU continues to increase across all of our product lines. And I think the other place that we're going to see our growth is coming from the increased ARPU in general. And then third, as you mentioned, just larger deals. And we've actually started to build that muscle internally, which is part of it. It's not about are the customers there, it's are you able to go service them and go sell to them. And that is one thing that we're learning over time, right? As the company has grown up, as almost all inbound to start with an SMB focus, building out that field motion, everything that's needed around it, it's still a journey. And we've been hiring a lot of great talent who've been there, done that, and now kind of building out the piece parts to go execute against that. And so yes, we are confident that that's where the growth is going to come from. We obviously have to go execute to go get that growth, and we do have the levers on top of what we think is our baseline to kind of accelerate that. But we have to see this play out quarter-over-quarter.

Yes. And this is going to be a 2-part question, but you mentioned on the Freshservice side, that being the biggest driver. So when we look at that piece, it looks like the guide assumes that you'll maybe grow in a CAGR in the low 30s versus closer to the low 40s that you guys are growing at today. So I know some of the pushback there has been, well, it doesn't assume as big of a de-sell. In terms of -- it could just be as simple as some of the demand tailwinds that you spoke about earlier is really being the drivers behind that business, but maybe you can touch on there. And then the second part of the question is, I think one question that we get a lot is, is there true cross-sell synergies between the Freshdesk and the Freshservice side? Can you take advantage of the base that you already have today? And like are those 2 truly separate? Are there cost synergies between them? What does that mean for long-term margins? Lots in there, but...

I get it. It's funny because, the Freshservice, we do think part of it is the law of larger numbers, right? Just [ starting ] to maintain that growth rate. It's funny because I've had investors say why wouldn't -- you're being way too conservative, it should grow a lot faster. The market there is huge, right? And we're not that big of a company. So we should be able to go achieve those growth rates, and it's not like we have to go steal a lot of market from anybody. And so that's why we feel a little bit confident there. On the -- what was the second part of the question?

I know I threw a lot at you in one question. But the second part was just on the cross-sell.

Cross-sell motions, yes. The Freshservice to Freshdesk and Freshdesk to Freshservice, there isn't a natural synergy between those products, meaning that there are a couple of use cases that they are integrated and those use cases, specifically, say, for software companies or tech companies, where something happens to the customer base that comes in and you have to have like an ITOM incident management response. And those use cases are easy to sell. But that's not really the reason to buy. I think our opportunity is that Freshservice has been doing so well. It's loved by our customers. That customer is the CIO. And that CIO usually has a lot of influence over the other buying decisions that are being made. And if one of those buying decisions is on a new support solution, we should be in that conversation specifically if we already are a trusted vendor. When I talk about the field motion that you need to build out kind of this muscle and this expertise, that's something we've never really had in terms of customer relationships and being able to have executive sponsorship. That's something we're working on that we think we can be able to leverage better in the future.

Perfect. And I'll give you one final question just on margins. So as we look at your CY '26 revenue guide, I guess how are you thinking about balancing margins and growth? And then to the extent that Freshservice becomes bigger, you might have -- there might be more incremental investments that you have to make to push the upmarket motion. How do you think about all of that playing out?

Yes. On the sales and marketing side, which is the last piece, I feel like we've built out that infrastructure, and we've made a lot of the investments already and so now it's tweaking those investments. In terms of margin structure on the '26, where we said $1 billion, the other thing we said was we're going to hit Rule of 40 by 2025 and be 20% growth, 20% free cash flow margin. And then beyond that, the capability to increase cash flow margins is there, and we just have to see where we go. I would prefer that that Rule of 40 actually shifts more to growth, right? And we will spend more if we think we can grow faster. We just need to be able to do it efficiently. And so we would make the option like if we could get it to 25%/15% on growth, we would absolutely do that. And we've been very open with investors about that. But in terms of incremental investment specifically in sales and marketing, it felt like we've already built the infrastructure, we just need to go make it really efficient.

Perfect. Well, that's all the time that we have. Tyler, thanks so much for joining us today. Really appreciate it. And thanks, everyone, in the audience as well, too.

Awesome.

Perfect.