Freshworks Stock: Growth Doubles Amid SMB Slowdown (NASDAQ:FRSH)

A Quick Take on Freshworks

Fresh produce (NASDAQ:FRSH) went public in September 2021, raising approximately $1.03 billion in gross proceeds from an IPO priced at $36.00 per share.

The company provides companies with everything size with various online software to manage aspects of their business operations.

Despite evidence of a slowing economy and slower uptake by the middle and lower segments of the company’s customer base, management does not appear to be reducing expected operating losses for the next period.

I believe this may be a mistake; until I see significant steps to reduce operational losses, either through improved efficiency or reduced costs, I’m on hold for FRSH.

Freshworks overview

San Mateo, California-based Freshworks was founded to provide customer experience services and later expanded its offerings to include IT service management and other related customer relationship management capabilities.

Management is led by co-founder, Chairman and CEO Rathna Girish Mathrubootham, who has been with the firm since inception and previously held senior roles at Zoho Corporation.

The company’s main offerings include:

• Freshdesk – Customer Experience

• Freshservice – IT Service Management

• Freshsales – Sales CRM

• Freshmarketer – Marketing CRM

The company cultivates relationships with clients ranging from small to large companies.

Small companies are encouraged to use the self-serve portal, while mid-sized companies communicate directly or through channel partners. Large businesses receive outreach from the company’s direct sales organization.

As of June 30, 2022, the company counted 59,900 customers.

Freshworks Market and Competition

According to a 2021 market research report by Grand View Research, the global market for customer relationship management was estimated at $43.7 billion in 2020 and is expected to reach $98 billion by 2028.

This represents a forecast CAGR of 10.6% from 2021 to 2028.

The main drivers for this expected growth are the growing demand for integrated software suites to automate interaction with customers and prospective clients.

Also, below is a historical and projected future growth for the CRM industry in the US, from 2016 to 2028 by solution type:

Key competitors or other industry participants include:

• Salesforce (CRM)

• Zoho

• Microsoft (MSFT)

• SAP (SAP)

• Oracle (ORCL)

• Adobe Systems (ADBE)

• Zendesk (ZEN)

• ServiceNow (NOW)

• BMC

• Ivanti

• Atlassian (TEAM)

• HubSpot (HUBS)

• Sage (OTCPK:SGGEF)

• Different

Recent Financial Performance of Freshworks

• Total revenue by quarter has steadily increased over the past quarters:

• Total revenue per quarter grew in a similar fashion:

• Selling, G&A expenses as a percentage of total revenue each quarter rose higher and remained high:

• Quarterly operating losses worsened in Q2 2022:

• Earnings per share (Diluted) remained negative:

(All data in the above charts are GAAP)

Since its IPO, FRSH’s stock price has fallen 72.6% compared to the US S&P 500 index’s decline of around 12.7%, as the chart below indicates:

Appreciation And Other Metrics For Freshworks

Below is a table of relevant capitalization and valuation figures for the company:

Measure [TTM]	Value
Enterprise Value / Sales	6.15
Income Growth Rate	42.2%
Net Income Margin	-68.7%
GAAP EBITDA %	-68.1%
Market Capitalization	$3,840,000,000
Enterprise Value	$2,690,000,000
Operating Cash Flow	-$2,670,000
Earnings Per Share (Fully Diluted)	-$25.43

Click to enlarge

(Source – Alpha Search)

For reference, a relevant partially public comparable is Zendesk, which is currently in the process of being acquired; shown below is a comparison of their key valuation metrics:

Measure	Zendesk	Fresh produce	Difference
Enterprise Value / Sales	6.05	6.15	1.7%
Income Growth Rate	30.7%	42.2%	37.7%
Net Income Margin	-18.3%	-68.7%	274.7%
Operating Cash Flow	$169,530,000	-$2,670,000	-101.6%

Click to enlarge

(Source – Alpha Search)

A full comparison of the two companies’ performance metrics can be viewed here.

The Rule of 40 is a rule in the software industry that states that as long as the combined revenue growth rate and EBITDA percentage rate equals or exceeds 40%, the company is at an acceptable growth/EBITDA trajectory.

FRSH’s latest GAAP Rule of 40 calculation was negative (25.9%) in Q2 2022, so the company needs significant improvement in this regard, according to the table below:

Rule of 40 – GAAP	Calculation
Recent Rev. Growth %	42.2%
GAAP EBITDA %	-68.1%
Total	-25.9%

Click to enlarge

(Source – Alpha Search)

Commentary On Freshworks

In its last earnings call (Source – Seeking Alpha), covering Q2 2022 results, management highlighted the addition of nearly 1,800 net new customers and a ‘healthy rate of expansion among existing users, ‘ with 23% of its customer base using more than one product .

The company also expanded capabilities for its Q1-launched CRM for e-commerce product by redesigning its messaging offering so brands can respond immediately to customer support or other issues different channels.

Interestingly, management is seeing increased turnover in their SMB customer base, ‘especially at the lower end of SMB in companies with fewer than 50 employees.’

On the plus side, the larger size of the company’s customer base has shown more ‘resilience and they have continued to increase their investment in us.’

Larger customers now contribute 57% of the company’s ARR, and Freshworks’ net dollar retention rate has been steady at 115%, indicating good product/market fit and relatively efficient sales efforts and marketing.

Regarding its financial results, gross profit rose 40% year-on-year on a constant currency basis, although the negative impact from a stronger US dollar grew as the quarter progressed and will likely continue to grow in Q3.

Non-GAAP gross margin was 82%, similar to the prior quarter while Selling, G&A as a percentage of total revenue increased as did GAAP operating losses and negative earnings per share.

On balance, the company ended the quarter with cash and marketable securities of $1.2 billion, but used free cash of $10.2 million, so FRSH has plenty of liquidity for its future growth initiatives.

However, one reason for this liquidity is that the company pays significant compensation benefits to employees in the form of stock, which serves to dilute shareholders’ equity.

Over the past four quarters, it paid out more than $270 million in stock-based compensation.

Looking ahead, full-year 2022 revenue guidance is $495 million, a growth rate of approximately 33.5% compared to 2021. Management is maintaining its operating loss estimates for 2022.

Regarding valuation, the market values ​​FRSH at an EV/Sales multiple of around 6.15x.

The SaaS Capital Index of publicly held SaaS software companies showed an average forward EV/Revenue multiple of approximately 7.7x as of July 31, 2022, as the chart here shows:

So, in comparison, FRSH is currently valued by the market at a slight discount to the broader SaaS Capital Index, at least as of July 31, 2022.

The main risk to the company’s outlook is a more likely macroeconomic slowdown or recession, which could slow sales cycles and slow its earnings growth trajectory.

A potential upside catalyst in the stock could include a pause or slowdown in US interest rate hikes, which would boost its valuation multiple.

Despite evidence of an economic slowdown, management does not appear to be reducing expected operating losses for the next period.

I believe this is probably a mistake; until I see significant steps to reduce operational losses, either through improved efficiency or reduced costs, I’m on hold for FRSH.

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