FRESHWORKS INC FRSH
March 14, 2022 - 12:04pm EST by
jon64
2022 2023
Price: 17.21 EPS -0.61 -0.35
Shares Out. (in M): 312 P/E NM NM
Market Cap (in $M): 5,370 P/FCF NM NM
Net Debt (in $M): 0 EBIT -54 -36
TEV (in $M): 4,043 TEV/EBIT NM NM

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Description


The recent underperformance of enterprise SaaS was well-warranted…there was simply too much froth in the
market. But today, even if you still believe the entire sector to be over-valued (we would argue it's gone through fair
value at this point), there are pockets of opportunity where underfollowed stocks have seen technical pressures take
valuations well below take-private floors.
Freshworks is the best example we can find in the market today. It ticks all the boxes: recent IPO, unprofitable tech,
underfollowed, misunderstood, and a technical overhang from selling shareholders.
Elevator pitch
Freshworks is a long because it’s an Indian-based, cost-advantaged disruptor (wages ~1/7th of western competitors)
across multiple B2B SaaS segments like ITSM and CRM, and could see its revenues 10x over the next 10
years. Freshworks trades at 7-8x revenue, well under fair value because investors don’t like their overweight SMB mix,
higher churn, lower prices, Indian-based operations, and reputation as a Zendesk knockoff. We believe Freshwork’s
modern, easy-to-use, elegant, low TCO software has compelling economics even in the SMB space, but will also enable
them to follow the FTNT/RPD/SHOP path of migrating from SMB to enterprise.
In a bull case, FRSH’s end markets could grow ~9%/yr, expand share in existing markets from ~0.5% to ~2.0% over
the next decade, and get ~300 bps/yr tailwind from expanding into a new adjacent market every 2 years. That implies
revenue increasing from $500M to $5B over 10 years, or a 10x/25% CAGR. Freshworks currently trades at 7-8x
revenue, the mature multiple in 10 years at 22x NOPAT/40% EBIT margins/25% tax rate is ~7x, so multiple is a
modest 1% headwind to returns. Combined with a simplistic assumption that interim cash flows offset cash drag (20-
25% of the current cap), that implies a ~25% IRR over 10 years.
In a bear case, revenue growth rapidly decelerates from the current 45% annualized constant currency rate and instead
grows 30% over the next few years, in which case 7-8x becomes 3.5x at a flat stock price over three years. Given the
user facing nature of the product, that's well below the floor at which the business could be accretively run for cash.
Business description
Freshworks was founded in 2010 by Girish Mathrubootham, a product manager at Zoho. Freshwork’s first product was
Freshdesk, a customer service tool that competes with Zendesk. In the time since, they have rolled out software
solutions that compete with ServiceNow, Salesforce, Ultimate Software (or more accurately, point solutions in HCM),
and Hubspot. This puts them in 5 separate $10-30B markets, albeit at varying levels of market share.
We believe the most compelling opportunity for Freshworks lies in ITSM (IT Service Management), and the adjacent
ITOM (IT Operations Management) and ITACM (IT Automation and Configuration Management) verticals. Legacy
players like BMC ($2.2B revenue), IBM ($1.8B revenue), and Broadcom ($1.0B revenue) still have large installed bases
and are meaningful share donors to players like NOW and FRSH.
Freshworks has ~40% of its revenue in the US, ~40% in Europe, and ~20% in Asia. This contrasts greatly with its US-
based competitors who are ~60% US.
Freshworks skews to the lower and mid-market, with an estimated ~40% of revenue in SMB (
in the mid-market (500-5,000 employees), and ~20% in enterprise (>5,000 employees).
Freshworks is one of the first Indian SaaS companies to break out onto the international stage. They were willing to
take money from western VCs over the past decade, which has enabled them to accelerate their growth.
Freshworks IPOed in September 2021 at $36 per share, then peaked at ~$52 per share. Freshworks has reported two
uneventful quarters in line with our expectations for ~10% constant currency QoQ revenue growth. But then the SaaS
market imploded, approximately 80% of the shares became unlocked in February 2022, and we believe an anchor
investor distributed shares to its LPs, many of whom might not have mandates to hold onto equity positions. That all
took Freshworks to $18/share. When you consider they have $4/share of cash, this represents a 70% decline in the EV
from the peak.
 
 

Freshworks differentiation
We believe Freshworks is uniquely positioned to do well in the SaaS enterprise application space.
 
Low cost labor. Freshworks is based in Chennai, India. Although the company moved its headquarters to
California, >80% of the employees are still in India. The apples/apples cost of an engineer in Chennai vs San
Francisco is about 1/7th. Even with a portion of its workforce in the US and European countries, the average
spend per employee is approximately 1/3rd of peers like ZEN, NOW, or CRM
 
 
P
roduct led growth. Freshworks was founded with an inbound sales motion selling into SMB, largely on the back
of Google Ad Words. To be successful, the product from the beginning had to be incredibly easy to use, and the
trial/onboarding process seamless. Even today, click around on the website a bit and before you know it you'll
be sucked into a fully featured trial account, building integrations to your enterprise applications. Over time
they've merged that user simplicity with advanced features required to succeed in the enterprise market. The
CEO's background as a product manager means the technical stack is much more modern and integrated than
competitors like ZEN.
 
 
P
henomenal culture. This is qualitative, but incredibly important in the world of high growth enterprise
SaaS. Freshworks has a culture that embraces community, innovation, and a customer first mentality. As a result,
Freshworks is regarded as one of the leading software companies to work for in India, whether with Indian roots
or large multinationals. That means Freshworks can be highly selective when choosing among the myriad
software engineers graduating every year across India. Speak with former employees and you'll get a sense for
what we mean here.
 
 
C
ustomer feedback. We did many interviews and surveys as part of our research and the degree to which
customers love the product was overwhelming.Net promoter scores during our customer interviews approached
75-80%, a level higher than almost any other software company we've studied. Their satisfaction ratings on
websites like G2 and Gartner Peer Insights are above every one of their direct competitors. Speak with
customers and channel partners and you'll get a sense for what we mean there.
 
 
S
pending intentions. In one survey, only 1 decision-maker out of more than 50 said they expected to decrease
spending with Freshworks in the coming year. In our interviews we were not able to find an example of
Freshworks getting ripped out in favor of a competitor for product reasons…customers getting acquired or going
bankrupt were the culprits.
 
 
P
latform approach. There are a few ways to frame up their product suite, but here's one: they have 5 products
that are oriented around two data sets.First the customer (marketing, sales, and support) and second the
employee (HCM and ITSM). As Freshworks sells more applications into their existing customer base, they
gradually take the place of the CDP on the customer side and become a system of record for employees on the
employee side. Additionally, Freshworks has an application development platform (as many do in the space)
called Neo that allows for accelerated R&D, a third party app store, and customized app development for
customers. As products and platform extend into the organization across multiple decision makers, stickiness
increases dramatically over time.
 
Competitors often have a few of these elements, but not all, and we think the combination is powerful.
 
Why Freshworks is misunderstood by investors
 
SMB legacy. SMB is not necessarily a bad business…yes churn is higher but CAC is also lower. If you plot
enterprise oriented SaaS vs SMB oriented SaaS on a chart of growth vs margin, we find very little
distinction. Freshworks in particular services all of its SMB business using an inbound motion from India, and
we've heard that as a result SMB is its most profitable segment. Even if you're not a fan of servicing SMBs, SMB
currently only represents about 40% of revenue (vs 15-20% for competitors) and that's falling ~200 bps per year
as Freshworks gets traction in enterprise.
 
 

 
Retention rates. On the surface, Freshworks has good but not great retention rates (low 80s gross and 115
net). That's being dragged down, however, by the ~40% of revenue that services SMB, where bankruptcies and
employee turnover naturally increase churn. We've heard that if you strip out SMB (Freshworks' most profitable
segment, so hardly something you would want to toss in the garbage) you would end up at low 90s gross and 120s
net.
 
 
L
ow prices. Some investors don't like the fact that Freshworks very often wins on price, coming in 10-50%
below ZEN/CRM/NOW on headline price and 20-70% below on total cost of ownership. We love the fact that
they win on price. That means that every dollar of recurring revenue they currently have comes with a pricing
umbrella well above current price levels.
 
 
C
ovid pull-forward fiasco. Covid caused QoQ revenue growth volatility in 2020 that made for volatile YoY
comps in 2021. Optically YoY comps declined, but underlying growth over the past few years (looking through
the noise) has been stable in the mid-40s. The company didn't clearly articulate the impact during the IPO
roadshow process.
 
 
Exchange rates. Freshworks does not report constant currency revenue growth rates, yet has ~32% of its
revenue in a mix of currencies, primarily the GBP and EUR. If you use EUR as a proxy, currency was a tailwind
to both QoQ and YoY revenue growth through late 2020 and early 2021. In recent quarters it has become a
headwind. Making the adjustment, QoQ growth has been incredibly stable at ~10%, corresponding to YoY
growth of ~45%, even as Freshworks has continued to scale.
 
 
C
orporate makeover. Two years ago Freshworks was a private company headquartered in India that was in the
bottom left Gartner quadrant. Today they are a public company headquartered in California in the challenger and
visionary quadrants. We believe this transition has the potential to dramatically increase the number of bake-offs
to which Freshworks is invited.
 
 
D
iversification as protection. In enterprise software the biggest fear is that LTV/CAC suddenly declines along
with organic revenue growth due to an exogenous shock like a new upstart competitor or saturated TAM. In the
case of Freshworks, they are selling so many products in so many geographies to so many customer types that it's
highly unlikely a single shock could derail the growth momentum. And if the return on investment for R&D or
S&M dollars declines in any one area, they can pivot and reallocate those resources elsewhere.
 
 
I
nternational mix. Freshworks is ~60% international, vs competitors ~40%, so US investors don’t get as much
exposure. Some of the best success stories of Freshworks adoption at the enterprise level are coming out of
Europe.
 
 
Ma
ture margin. Freshworks is at near break-even adjusted margins (lower after SBC, which we always deduct as
an expense). The oldest legacy products like Freshdesk however, are anecdotally already at ~40% margins, while
investments are going into new products in new geographies.This gives us more confidence not only in the
mature margin this business can earn, but also the durability of growth over the next 5 years.
 
Risks
 
Mark-to-market. Freshworks does not generate earnings, nor do we want them to for many years. As a result
investors are forced to use rev multiples, gross profit multiples, or mature margin assumptions to back into fair
value. Investors lose their desire to use those tools during periods of market stress, and given the macro
backdrop we might not be anywhere near the bottom.
 
 
W
age inflation. Success begets success, and other companies are rapidly being launched and grown in Chennai
where Freshworks has the majority of its operations, largely targeted at other SaaS markets (Chargebee is going
after Zuora, for example). As a result, we believe wage inflation is currently running close to ~20% in
Chennai. Competitors are also dealing with inflation, and the INR generally depreciates with time due to higher
inflation in India, but a wide spread in California vs India wage inflation could chip away at Freshworks' cost
advantage over time.
 
 

 
Execution. We don't think you need to believe much of anything on the execution front to justify the current
valuation. But getting to $5B of revenue over 10 years will require world class execution, and with a company
straddling continents there are risks that the machine comes apart.
 
Valuation
There are a few fundamental reasons to believe 7-9x revenue is too cheap for an enterprise software company growing
low 40s at almost break-even margins, none of which rely on simply looking at peer EV/rev.For example:
 
Take-privates. H&F bought Ultimate software for 7x revenue in 2018. Thoma just put in a bid last month at 9x
revenue for ZEN, which we believe is worse positioned than Freshworks because they are lower growth, have
higher priced ARR, have more tech debt, and are a single product in a platform world. Ultimate and Zendesk
were growing 20-30% at the time of their offers, vs Freshworks growing >40% today…Freshworks is likely 3-5
years away from being as mature as Ultimate/Zendesk were at the time of their offers. Note that these reference
comps did not occur during peak bubble periods
 
 
B
ase rates. In enterprise software the average growth decay rate is ~85% (growth in year X is 85% of growth in
year X-1) and the average mature EBIT margin is ~35% (point at which rev grows 5%/yr). If you believe
Freshworks is merely average, the justified valuation today at a 20x mature NOPAT multiple and 8% discount
rate would be almost double where it trades today. We believe there's a long runway for global software spending
to continue growing HSD/yr, primarily at the expense of enterprise hardware and telco spend, in line with recent
trends and base rates.
 
The CEO is a unique individual who we do not believe is motivated purely by money. His primary goal is to 1) create
the first, biggest, and most admired enterprise SaaS company to be primarily based in India and 2) foster the next
generation of enterprise SaaS companies in India. But for what it's worth he has a restricted stock plan for 6M PRSUs
that vest at stock price triggers ranging from $70-200/share terminating on 1/1/2029, which would be a 4-11x return
over 6.8 years. We don't use that to inform our projections, but instead to simply illustrate the fact that the company has
a vision that extends well beyond selling more Freshdesk to SMBs.
 
Disclosure:
We and our affiliates are long Freshworks (FRSH US) and may buy additional shares or sell some or all of our securities,
at any time. We have no obligation to inform anybody of any changes in our views of FRSH. This is not a
recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own
research and reach your own conclusion.
 
 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

We believe catalysts will be 

(1) New client wins 

(2) Organic revenue growth

(3) Easing of technical selling pressure 

(4) M&A activity in the space 

 

 

  

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