Freshworks (FRSH): Correction Has Created An Opportunity

Freshworks’ (NASDAQ:FRSH) IPO came in at over 40x revenue. However, the stock has since seen significant correction despite strong revenue growth.

The one concerning aspect was the lack of free cash flow strength. Per the management’s 1Q 2022 commentary, from Q4 onwards, free cash flow should turn positive. We think the operating leverage kicking in can turn around the stock’s fortunes, and a 35%+ return from the stock cannot be ruled out.

What does Freshworks do?

Freshworks provides SaaS products for customer experience and IT service management, launching newer products into salesforce and marketing automation.

As part of the company’s product evolution, Freshworks is now focusing on building a unified customer record, which will combine data across marketing, conversational support, self-service bots, and sales into a single unified customer record. The first industry that Freshworks has targeted is the e-commerce market with a partnership with Shopify (SHOP), with plans to expand into the likes of WooCommerce and Magento (ADBE).

The company has been focused on SMBs, and a USP of Freshworks’ products has been the velocity at which these products can be rolled out – 8 to 10 weeks vs. the 12 to 18 months in the case of traditional players.

Interestingly, much of the management team has worked across competitors and thus knows the market quite well.

Business performance

As a subscription software or SaaS company, one of the key metrics is the ARR or the annualized recurring revenue, which the company defines as follows:

For monthly subscriptions, we take the recurring revenue run-rate of such subscriptions for the last month of the period and multiply it by 12 to get to ARR.

Source: 10-K – 2022

Freshworks’ customers with ARR of more than $5K and $50K have seen sustained growth, with the management remaining upbeat about the momentum and visibility, especially from the newer launches and partnerships.

While 1Q 2022 revenue grew 42% y/y to $114.6 million, beating estimates, the stock fell on concerns around demand, as evidenced by the commentary around billings.

From a new business perspective, billings growth was impacted by a lower number of large deals closed in the quarter. While we added a healthy number of new customers in Q1, the average customer size was smaller compared to prior quarter as our field operations continue to build out and ramp up productivity for the mid-market and larger customers. We’re also seeing a very competitive hiring environment on the go-to-market side, especially in Europe. So, this has impacted our sales realization in that region.

While we don’t manage the business to a calculated billings metric due to the overall uncertainly around European market and the time it takes to build up go-to-market operations, we expect the calculated billings growth to moderate in Q2.

Source: 1Q 2022 Freshworks’ Earnings Call

The key issue appears to be insufficient GTM folks in the field, leading to inadequate growth. One of the reasons the management highlighted was challenges in hiring, which have significantly changed over the last 45 days. While the uncertainty from Europe and FX remains, we think Q2 billings may surprise on the upside.

Financials

The key concern around demand slowdown can be summarized in the following graph.

We note that the decline in billings growth relative to the revenue growth has led to speculation around if the demand for Freshworks’ products is strong enough. In addition, management commentary on insufficient hiring is evident from the SG&A expense as a percentage of revenue.

We think the management is going to benefit from the recent spate of layoffs in startups and the consequent slack in the job market. The less challenging environment could also allow for a lower cash burn.

Additionally, the management’s guidance of a 35% growth in F2022 looks conservative given the momentum in customer addition metrics. While baking in challenges to GTM makes sense, after adding 2,100 customers in 1Q 2022, unless something drastic happens, we think the company could clock revenue growth of over 40%.

Given Freshworks’ size, growth and gross margins, we find the company’s characteristics closest to Zendesk (ZEN), Atlassian (TEAM) and ServiceNow (NOW).

We note that Freshworks’ gross margins are north of 80%, and thus we apply a gross margin weighted P/S multiple to express the potential upside in the company’s stock price.

Our analysis yields an upside of 55-65% from the current levels, to which a conservative investor may apply a 20% reduction to get a 35-45% range. The 20% reduction is to account for a worsening macro environment.

Risks to our thesis

We think the main risk to our thesis is how Freshworks turns around the company’s GTM execution issues.

I think, it is an internal execution on the GTM side that we are still dealing with ramping reps who have to kind of close more deals. And we will — we have made the investments, and we are confident that will pay off in the coming months and quarters.

Source: 1Q 2022 Freshworks’ Earnings Call

Freshworks is a relatively young entrant in customer service and IT service management, where competition for talent is immense. The management’s approach to managing its marketing strategy will significantly impact cash burn, profitability, and consequent ability to attract talent. Thus, the next quarter’s results will be critical for Freshworks to establish itself as a serious player in the service management market.

Another risk is around macros and the spillover impact the geopolitics of Russia-Ukraine could have on Europe and the forex.

Conclusion

Freshworks has lost over 2/3 of its value from the time of the company’s listing, with the stock continuing to slide downwards. We think the management’s commentary of another $20 million in FCF has not inspired much confidence in the stock. However, as we look ahead, the traction in business could positively surprise, leading to 40-60% returns.