Small-Cap Software Watch: Freshworks

Freshworks stock is holding above the record low of $10.51 reached last June.

Freshworks (FRSH, $15.07), a provider of front- and back-office software for SMBs, is navigating its way through an increasingly challenging macro environment.

While the company in early November reported Q3 results that beat on both the top and bottom lines, there were some decelerating metrics—including billings growth and net dollar retention. Freshworks faces more headwinds around customer expansions and could see rising churn.

Freshworks will report Q4 results on February 7. The consensus revenue estimate of $130.2 million (growth of 23.5%) sits in the middle of the guidance range of $129.2 million to $131.2 million.

Revenue in Q3 rose 33% (+37% adjusted for FX) to $128.8 million, above the consensus of $125.4 million. The company lost a penny a share, topping the consensus by four cents. Gross margin was healthy at 83%, up 100 basis points year over year.

In Q3, billings of $136.9 million gained 25% (+31% in constant currency), but this was a deceleration from the Q2 growth rate of 33% (+36% in constant currency). For Q4, Freshworks guided billings growth to 16% (+22% in constant currency).

The company in Q3 added about 1,700 net new accounts, bringing the total customer base to 61,600+. There are 16,713 customers with annual recurring revenue (ARR) above $5,000, up 19% year over year (+23% adjusted for FX).

Freshworks is having its best success at the upper end of the customer spectrum. More of its products now appeal to the mid-market (customers with more than 250 employees), which represents 57% of Freshworks’ total revenue. In Q3, the number of customers with ARR above $50,000 rose 36% (+44% adjusted for FX) to 1,717. This large-customer cohort accounts for about 43% of total ARR. Freshworks’ sweet spot for large deals is $50k to $200k.

Larger customers have greater potential for multi-product sales. Freshworks offers a broad portfolio of products across customer service engagement, messaging, IT service management (ITSM), enterprise service management (ESM), marketing automation and CRM. Today, 24% of the Freshworks customer base has adopted multiple products (this group represents half of the total business).

In the current macro, seat expansion is an important issue. A significant part of Freshworks’ expansion motion is tied to agent additions across the customer base. If companies aren’t expanding as much, they won’t be hiring as many agents. The net dollar retention rate in Q3 fell to 107% from 111% in the June quarter. While the Q3 FX-adjusted retention rate of 113% was better, management sees this metric falling to 110% in Q4.

In addition to boosting its mix of larger customers, a good way for Freshworks to help propel its expansion business in this environment (and prop up net dollar retention) is through ongoing product innovation.

Freshdesk, the core product for customer service reps, has been refocused to emphasize chat and conversational messaging. The Freshchat offering now has an AI-powered suggestion functionality that helps customer service reps improve response times.

Freshworks has infused AI technology across all of its major products. Real-time AI helps organizations maximize agent performance, lower costs and boost customer satisfaction rates by as much as 3.5x, says Aberdeen Strategy & Research. By 2026, conversational AI deployments in contact centers are expected to reduce agent labor costs by $80 billion, according to Gartner. Freshworks customers are won over by the immediate ROI offered by the company’s products.

Freshservice, the ITSM solution, has become the company’s largest contributor to ARR growth. Aimed mainly at the mid-market and small enterprise segments, the product has relatively high retention rates. Freshservice is often the first ITSM product bought by a mid-market enterprise. Given the large size of the ITSM market, Freshworks sees the opportunity to significantly expand its presence, operating between ServiceNow at the high end and Atlassian at the low end.

In October, Freshworks announced Freshservice for Business Teams, a new offering that enables departments outside of the IT function (including HR, facilities, legal and finance) to securely provide uninterrupted service delivery for each department. With this ESM product, multiple teams within an organization can coexist independently within a single Freshservice instance, with the ability to configure, manage and control access to their individual workspaces.

For 2022, Freshworks’ latest revenue outlook of $494 million to $496 million represents growth of 33% to 34% (+36% to +37% adjusted for FX). At recent prices, the enterprise value stands at 5.7 times the 2022 revenue guidance midpoint. On the 2023 consensus top-line estimate of $595.7 million (growth of 20.3%), the multiple is 4.8x.

Freshworks shares are holding above the record low of $10.51 reached last June. The stock has rallied 14.5% since the Q3 report on November 1. Freshworks went public in September 2021 at $36 a share, with an opening trade of $43.50.

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