Freshworks Inc. (NASDAQ:FRSH) Q3 2023 Earnings Call Transcript

Freshworks Inc. (NASDAQ:FRSH) Q3 2023 Earnings Call Transcript October 31, 2023

Operator: Hello, and welcome to the Freshworks Third Quarter 2023 Earnings Conference Call. At This time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. It is now my pleasure to introduce Vice President, Investor Relations, Joon Huh.

Joon Huh: Thank you. Good afternoon and welcome to Freshworks’ third quarter 2023 earnings conference call. Joining me today are Girish Mathrubootham, Freshworks’ Chief Executive Officer; Dennis Woodside, Freshworks’ President, and Tyler Sloat, Freshworks’ Chief Financial Officer. The primary purpose of today’s call is to provide you with information regarding our third quarter 2023 performance and our financial outlook for our fourth quarter and full year 2023. Some of our discussion and responses to your questions may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on Freshwork’s current expectations and estimates about its business and industry, including our financial outlook, macroeconomic uncertainties, management’s beliefs, and certain other assumptions made by the company, all of which are subject to change.

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These statements are subject to risks, uncertainties, and assumptions that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks include, but are not limited to, our ability to sustain our growth, to innovate, to reach our long-term revenue goals, to meet customer demand, and to control costs and improve operating efficiency. For discussion of additional material risks and other important factors that could affect our results, please refer to today’s earnings release, our most recently filed Form 10-K and Form 10-Q, our Form 10Q for the quarters ended March 31, 2023, and June 30, 2023, and our other periodic filings with the SEC. Freshworks assumes no obligation to update any forward-looking statements in order to reflect events or circumstances that may arise after the date of this call, except as required by law.

During the course of today’s call, we will refer to certain non-GAAP financial measures. Reconciliations between GAAP and non-GAAP financial measures for historical periods are included in our earnings release, which is available on our investor relations website at ir.Freshworks.com. I encourage you to visit our investor relations site to access our earnings release, supplemental earnings slides, periodic SEC reports, a replay of today’s call, or to learn more about Freshworks. And with that, let me turn it over to Girish.

Girish Mathrubootham: Thank you, Joon, and welcome everyone. Thank you for joining us today on Freshworks earnings call, covering our third quarter of 2023. We delivered another solid quarter of execution as we outperformed our previously disclosed estimates across our key financial metrics. Our revenue exceeded the high end of our financial outlook range, coming in at $153.6 million for the quarter. We surpassed our estimates for free cash flow with $22.1 million in Q3, and we improved our free cash flow margin to 14%. We also held our first Investor Day in September, where we showcased our products and outlined the path that we believe will drive us towards becoming a $1 billion company and beyond. Freshworks continues to reap the benefits of three industry tailwind.

Businesses of all sizes are having to transform to compete digitally; expectations for customer and employee experience are evolving to center around modern messaging and AI is breaking down silos offering richer insights to help businesses understand much more about their customers and employees. This quarter, in particular, we added new generative AI capabilities across products and opened up our Freddy Insights beta program following Freddy Self-service and Freddy Copilot in Q2, which is intended to unlock more value out of our existing product suite. You’ll hear me talk about AI quite a bit today, starting with customer support. I’m really excited by the traction we’ve been seeing since launching our customer service suite in August. It’s our all-in-one solution to combine bot, modern messaging, and ticketing.

In the first two months, our sales team signed on more than 200 customer service suite customers from new and existing customers. And we are seeing higher levels of engagement with the product than with Freshchat alone. The suite not only saw great traction with new customers, but also with longstanding ones, including a large US TV network and a high fashion jewelry company who decided to migrate to help them scale self-service features with our bot capabilities. An early adopter of the customer service suite, Fastway Couriers in South Africa, delivers over 16 million parcels annually to an area nearly twice the size of Texas. The company is growing, but found its previous provider offering a disjointed customer service experience across different channels.

Now, with the customer service suite, agents are able to better address this issue, can handle live chats with automation, and gain deep insights into ticket trends. We continue to invest in cutting edge AI capabilities for our customer support users. In our initial beta for Freddy Copilot, we were predominantly focused on driving agent productivity. We have heard great feedback from our customers, including Monos, a luxury luggage brand we featured during our Investor Day. Thomas Cook, a popular global travel company in the UK using Freshdesk since 2021. And iCar, a business process outsourcing company with 40,000 employees, are beta testing Copilot features to further enhance agent productivity. Steady Copilot adoption and usage among customer service customers increased meaningfully from Q2.

In Q3, we continue to see growing demand for our IT products with mid-market and enterprise customers. We’ve been to the unified service operations platform that enables customers to improve service reliability. Our customers, including ChildHope Group, Valley Children’s Healthcare, and Travelopia, see great value in our unified product. ITOM, in particular, is gaining traction with momentum for Freshservice’ major incident management feature. We added new capabilities to this feature and the customer base is growing. Almost 1,500 customers now take advantage of post-incident reports, automated major incident creation via Alert, and organizational updates through a branded status page. We continue to harness the power of generative AI to enable IT and other business users to focus on high value work by using auto generated ticket summary and ticket response suggestions.

Our newest beta release includes GenAI-powered virtual agent that eliminate forms to create a more conversational experience for employees. Early adopters of these new AI features for Freshservice include existing customers, Restaurant365 and Confluent Health. Freshservice customer adoption of these features has more than doubled since Q2. Through our continued innovation to meet the IT needs of large enterprises on the mid-market, we believe we are increasing mindshare with CIOs and anticipate that this will enable us to execute on the broader ITSM opportunity. On to sales and marketing. We continue to execute on our vision of delivering an easy to use, quick to set up smart CRM that assists sales teams in generating leads, increasing conversion and accelerating revenue.

In Q3, we made improvements to the inbound experience in our sales and marketing products. We revamped the UI of Freshsales to improve user efficiency, productivity and data accessibility. The upgraded interface for sellers helps boost context, AI-powered actions, and team collaboration for faster deal closures. For example, a local cabinet maker in Georgia named Click Studios uses both Freshsales and Freshdesk to help support their sales teams to collaborate better, which has helped Click Studios improve its sales cycle by up to 35%. We also continue to strengthen our AI capabilities for marketers to improve campaign creation, while boosting efficiency, conversion rate, and customer satisfaction. In summary, Q3 innovation was centered around unlocking more productivity for our customers through AI-powered customer service, IT, and sales and marketing products.

And we will continue building an offering richer insights to help businesses understand their customers and employees. Now, over to Dennis, who will give more detail on the opportunities we are realizing with customers and the ongoing impact of changes we are making to our GTM operations.

Dennis Woodside: Thanks, G, and thank you, everyone. We appreciate you joining us for today’s call. As we talked about at our Investor Day, on top of product innovation, a few key growth drivers are helping us deliver on our targets for revenue, operating profit, and free cash flow. Let me provide some highlights from Q3. Firstly, our unique go-to-market approach efficiently serves the Fortune 5 million, combining an efficient inbound sales motion, growing field sales presence, and a partner ecosystem that’s built to scale. Large customers like TriPoint Homes and Qualfon turned to Freshworks along with mid-market customers like Salvation Army Australia, ASPCA, and Jackson Family Wines. We added nearly 1,000 net customers in the quarter, resulting in a total of over 66,600.

While we’re addressing companies of all sizes, we’re also targeting larger, higher-yielding customers. In Q3, Freshworks customers paying us over $50,000 in ARR grew 32% year-over-year or 30% on a constant currency basis. This cohort continues to represent 46% of our ARR as larger customers fuel the growth of our business. One example, a national home builder has $4 billion in annual sales and 6,000 employees. They needed a consolidated platform that manages ticketing, ITSM, and asset management to improve their efficiency given each of those was previously managed in disparate systems. They chose Freshservice and added marketplace integrations to help them scale their global service management needs. Another large company using Freshservice is Qualfon, a leading business processing outsourcer with 15,000 employees.

They used a legacy provider’s ITSM tool for years, but it never delivered on automation. Qualfon chose Freshservice because it is easy to use and supports employee needs right out of the gate. They can now automate over 2,000 requests per month and saw an average resolution time improvement of 70%. Looking at our opportunity for expansion, higher rates of multi-product adoption with larger customers are contributing to this growth driver. In Q3, 25% of our total customers used more than one product. In our larger customers, we’re finding more than half of our $50,000 plus ARR customers are using multiple products. One example is Giant Eagle, a retailer with more than 470 stores and approximately 36,000 team members. Giant Eagle chose Freshservice for its user friendly, results driven platform.

And this summer introduced Freshchat to better measure employee engagement. Building off an encouraging increase in self-service among team members, Giant Eagle is now eager to integrate other communication platforms like text. Western Financial Group is another great example of Freshservice to Freshchat expansion. The Canadian insurer needed an enterprise tool to allow support teams to collaborate and respond effectively to frontline teams, keeping data and reporting separate. Moreover, they wanted to unlock tools for change, problem and asset management and CMDB. They chose Freshservice because of its vast automation opportunities, ease of use and clean interface. Most recently they have expanded and begun using FreshChat. Turning to our SMB opportunity, this remains large.

As G mentioned earlier, we’re taking advantage of that by enhancing our inbound motion with a view to driving higher conversions and attracting stickier customers. We saw encouraging signs in the SMB segment in Q3, as the churn rate improved year-over-year and also quarter-over-quarter. Millions of SMBs need to adopt AI and automation now to stay competitive, and we believe AI can greatly simplify customer and employee experiences. Underscoring this, many of our AI beta customers today are SMB and mid-market companies, including Ultrafabrics, an early pioneer of socially conscious fabric manufacturing, Jacob Stern & Sons, a distributor of specialty agricultural products since 1850, and Virtual Identity, a digital creative agency. Each of these customers uses Freddy Self-service to automate level 0 and level 1 support with modern virtual agent conversations.

We’re embedding AI capabilities across our products, as this is a critical growth driver for us. New features include contact scenario for Freddy Insights, which analyzes top contact scenarios in tickets and conversations and helps deploy bots for them. This is just one of many enhancements we released with Freddy AI to deliver more value to our customers in Q3. Our plan is to monetize increased automation through bot sessions in a consumption or usage based model. As automation frees up agents to focus on higher value work, we can also assist with our Copilot add-on that helps them be more productive. Our continued traction with larger customers over $50,000 in ARR, combined with our expansion motion and large SMB opportunity, create a go-to-market motion unique to Freshworks.

We believe it is this combination of growth levers that gives us confidence in our ability to reach our goal of $1 billion in revenue in the next three years. I’m also excited to announce the upcoming appointment of a new management team member who will be crucial in helping us reach that big goal. Mika Yamamoto will join us as Chief Customer and Marketing Officer on November 20th. Mika has proven executive leadership experience at large public tech companies with deep technology, sales, and marketing experience, serving multiple buyers that are relevant to Freshworks. She was most recently the Chief Customer Experience and Marketing Officer of F5 and was previously the President of Marketo, Chief Digital and Marketing Officer at SAP and held senior roles at Amazon, Gartner, and Microsoft.

Now over to Tyler to go through the Q3 financials and talk about how we’re driving efficiency.

Tyler Sloat: Thanks, Dennis, and thanks again to everyone for joining us. Before I get started, I want to thank you once again to everyone who attended our first Investor Day. It was great to spend time with many of you in person and to provide an update on the Freshworks story. Once again, we had another quarter of good execution in Q3. We beat our revenue growth estimates and continue driving additional leverage in the business to expand both non-GAAP operating and free cash flow margins quarter-over-quarter. We continue to realize the financial benefits resulting from the operational changes made earlier in the year, and we’re creating a healthier position to drive profitable long-term growth for the business. For our call today, I’ll cover the Q3 financial results, provide background on the key metrics, and close with our forward-looking commentary and expectations for Q4 and the full year 2023.

I’ll also include constant currency comparisons for certain metrics to provide a better view of our business trends. As a reminder, most of our discussion will be focused on non-GAAP financial results, which exclude the impact of stock-based compensation expenses and other adjustments. Starting with the income statement, revenue grew 19% year-over-year to $153.6 million on a reported basis, and 18% adjusted for constant currency, as we’re beginning to see the positive impacts on currency rates for the euro and pound against the dollar over the past year. ITSM deal activity continued to drive much of the growth in Q3, while expansion rates ticked down slightly in the quarter. Turning to margins, we had another strong quarter of non-GAAP gross margin of 84% as we efficiently scale the business.

In Q3, we achieved a non-GAAP operating margin of 11%, which represents a 3 percentage point improvement quarter-over-quarter. This is driven by lower-than-expected headcount-related costs, some delays in spend, and ongoing improvements on operating expenses. Turning to our operating metrics, we have two key business metrics, net dollar retention and customers contributing more than $5,000 in ARR. Net dollar retention was 108% in the quarter which includes a 2 percentage point benefit from FX. In Q3, our overall churn came better than our initial estimates, slightly improving from the prior quarter. Looking ahead, we are planning for the lower net expansion trends to persist for the remainder of the year as we expect net dollar retention to be approximately 105% for both constant currency and, as reported, in Q4.

Moving to our other key business metric of number of customers contributing more than $5,000 in ARR. This metric grew 17% year-over-year to 19,551 customers in the quarter and continues to represent 88% of our ARR. On a constant currency basis, this customer metric grew 16% year-over-year. For our larger customer cohort, contributing more than $50,000 in ARR, this cohort grew 32% year-over-year to 2,268 customers and represents 46% of our ARR. Adjusting for constant currency, this cohort grew at 30%. We added nearly 1,000 net customers in the quarter, which was an increase from Q2. We ended the quarter with a customer count of approximately 66,600, as we continued our focus on attracting higher yielding customers in building a healthier base and driving a higher ARPA.

Moving to calculated billings, balance sheet and cash items. Calculated billings grew 21% year-over-year to $165.3 million and 19% on a constant currency basis. Factors including timing duration of contracts and revenue reserves in the quarter create a slight benefit of 1% to these growth numbers. Looking ahead to Q4 2023, our preliminary estimate for calculated buildings growth is 18% as reported and 17% on a constant currency basis. For the full year 2023, we expect calculated buildings growth to be similar to our expected annual revenue growth of approximately 20% for both as reported and constant currency. During the quarter, we generated $22.1 million in free cash flow, ahead of our estimates and reflective of the efficiency improvements we’re making in the business.

We ended the quarter with a similar balance for cash, cash equivalents, and marketable securities of $1.16 billion. We continued to net settle vested equity amounts using $24 million during the quarter, which is reflected in financing activities. And this activity is excluded from free cash flow. As we look forward to Q4, we plan to continue net settling invested equity amounts, resulting in Q4 cash usage of approximately $18 million using current stock price levels. For the year, we expect to use approximately $70 million to net settle invested equity amounts. Given the meaningful operational efficiencies we’ve realized so far this year, we are raising our free cash flow estimates for the full year 2023 by $15 million to $75 million. Turning to our share count for Q3.

We had approximately 327 million shares outstanding on a fully diluted basis as of September 30, 2023. The fully diluted calculation consists of approximately 295 million shares outstanding, 29 million related to unvested RSUs and PRCs, and 3 million shares related to outstanding options. Let me now provide our forward-looking estimates. For the fourth quarter of 2023, we expect revenue to be in the range of $156.7 million to $159.3 million, growing 18% to 20% year-over-year. Adjusting for constant currency, this reflects growth of 17% to 19% year-over-year. Non-GAAP income from operations to be in a range of $5.5 million to $8.5 million, and non-GAAP net income per share to be in the range of $0.04 to $0.06, assuming weighted average shares outstanding of approximately 303.3 million shares.

For the full year 2023, we expect revenue to be in the range of $593 million to $595.5 million, growing 19% to 20% year-over-year. Adjusting for constant currency, this reflects growth of 19% to 20% year-over-year. Non-GAAP income from operations in the range of $38.5 million to $41.5 million. And non-GAAP net income per share to be in the range of $0.23 to $0.25, assuming weighted average shares outstanding of approximately $300.1 million. Given the US dollar trends over the past year, we saw a slight positive impact to our growth rates in Q3. Our forward-looking estimates are based on FX rates as of October 27, 2023. So any future currency moves are not factored in. Let me close by saying, we continue to execute on our goals in Q3. We maintain our rapid pace of product innovation, realize the benefits of operational changes made earlier this year, and remain focused on the growth initiatives to help drive momentum into 2024.

We’re excited and look forward to our many opportunities ahead. And with that, let’s take your questions. Operator?

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Q&A Session

Operator: Thank you. [Operator Instructions] And our first question comes from the line of Scott Berg with Needham & Company. Pardon me, Scott. Please check your mute button. Okay. One moment for our next question. And our next question comes from the line of Ryan MacWilliams with Barclays.

Ryan MacWilliams: Hey guys, thanks for taking the question. Pleased to see you continue to work to improve profitability here. Just asking about how things moved through the third quarter. Like, how would you say your new business did in the month of September and how has October been so far? Thanks.

Dennis Woodside: Hey, sorry about that, Ryan. Thanks, Ryan. I think the question is around linearity. And so, as we went through September, it kind of played out as we expected. Meaning that, we’ve been dealing with larger companies and larger deals. And over the last, let’s call it, year, it become a little bit more back end loaded. So that was expected. October, the guidance that we just gave out is — it takes into account everything we see or try to call it as we see it. So October is going as we expected as well.

Ryan MacWilliams: Appreciate that. I know it’s early, but we’ve heard a lot of customer interest around Freddy AI. So any more detail on the timing of the rollout there, any early expectations, or just any more additional commentary around how that can be initially adopted within your customer base, like maybe a penetration rate or what kind of customer you can see that first in. Thank you.

Girish Mathrubootham: Sure, Ryan, I’ll take that. This is Girish. So we have, actually, if you remember last quarter during Investor Day, we actually said that several of our customers were beta testing our Freddy AI, specifically Freddy Self-service, which is the self-service automation capability for customer service and employee service. That is being used by our customers. We are monetizing it through our bots in the customer service platform. And Freddy Copilot and Freddie Insights, this quarter we have actually put it in — when I say this quarter, I mean Q3, we have actually put it in beta and to our customers. Thousands of customers are using it. Our plans for monetizing Freddy Copilot would be, we’re thinking of Q1 2024 is when we would start charging for Copilot and that’s an add-on to agency licenses. We are still working with customers on Insights, we have not finalized the pricing for Insights yet.

Ryan MacWilliams: Appreciate the color. Thanks, guys.

Operator: Thank you. One moment please for our next question. Our next question comes from the line of Scott Berg with Needham & Company.

Scott Berg: Hi. Hopefully everyone can hear me this time. Congrats on the strong quarter and thanks for taking my questions. I guess a couple, Dennis, I wanted to start with you. Sales is quarter, you seem quite pleased with them. One of the trends I’ve noticed over the last couple of years is your third quarter kind of customer ads are — you always have a seasonal dip versus the second quarter kind of results. And this year looks like it’s very much the same. Can you help remind us what you see internationally that might be causing a little bit of that change from Q2 to Q3? My guess is that, it has something to do with just European sales cycles. But I didn’t know if there’s anything more nuanced to call out there in particular.

Dennis Woodside: Yes. Thanks, Scott. Yes, nothing really nuanced there. I don’t think we had anything this quarter related to European sales cycles. We continue to see strength in the larger accounts, continue to see strength in IT. And we did see an uptick in net ads to — around a thousand net ads for the quarter from last quarter. So, we didn’t see the kind of dip that perhaps we’ve seen in the past. Remember, last quarter — in Q2 we had a free offering for our Freshsales product that we then pulled back, and that has resulted in the increase in the overall net ads for Q3.

Scott Berg: Got it, helpful. And then I wanted to just follow-up on the question on improving win rates, or excuse me, improving churn down market. I think that’s always super interesting because a point improvement there makes a big difference both on the top line and bottom line profitability. How should we think about your opportunity to improve that churn in that segment? SMB churn across software is always notoriously low. I know you all have had some success improving that number, but how do we think about what that kind of runway for improvement looks like maybe over the next several quarters?

Tyler Sloat: Yes. Hey Scott, this is Tyler. You’re right, we’ve actually done a really good job on churn just as a company over the last, I would call it, year plus. Well, we’ve had quarters where it kind of remained stable and then other quarters where we actually make some good improvement on it. This past quarter was a company best for us in terms of churn in general. And that’s across the board, across the products. On the SMB side, I think it’s more characteristic that the products are getting better and we’re getting also better at kind of focusing on the right ICPs for ideal customer profiles for our customers, even on SMB, which has led to maybe slightly lower total number of customers, which we’ve seen in the last couple of quarters, but better customers in some cases.

So I do think that going forward the improvements are going to be more subtle, but I do think that we do have a little bit of room to go in terms of improving turn over the next year, year and a half.

Scott Berg: Excellent. Very helpful. Thanks for taking my questions and congrats in the strong quarter again.

Dennis Woodside: Thanks, Scott.

Operator: Thank you. One moment please for our next question. And our next question comes from the line of Pinjalim Bora with JP Morgan.

Pinjalim Bora: Hey, guys. Thanks for taking the questions, and congrats on the quarter. I want to ask you on the bot side, can you help us maybe understand what portion of the overall ARR today is driven by bot-based pricing? And how should we think about kind of the changes in the pricing and packaging that went into effect in August, how is that going to be layered into the model?

Tyler Sloat: Yes, I’ll start with that, talk about the financial part. Pinjalim, this is Tyler. We changed the pricing at the end of Q2 in terms of our chat pricing, which then — the bots are kind of embedded in that, which would also embed the Freddie Self-service capabilities. It’s really, really new. And so, we don’t have that much embedded in terms of the new feature functionality, we do have a decent amount of chat revenue, and we would expect that to continue to kind of increase as we progress here. The other AI capabilities, right, we haven’t started charging for it, they’re still in beta, and they will be coming out kind of Q1 and that’s really Copilot will be the next one that’s coming out. And so, every quarter we expect to have a little bit more increase on price of service, again, that’s going to be reflected more in chat usage.

Pinjalim Bora: Yes, understood. And Tyler on that topic then it seems like you have a few tailwinds like going into next year, the bot-based pricing, the AI SKUs that I think Girish said will be monetizing in Q1, maybe potential stabilization on the NDR metric. Obviously macro and geopolitical climate is a wild card, but help us understand how are you thinking about 2024? What are the put and takes as we look forward?