Value Investors Club / FRESHWORKS INC (FRSH)

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.

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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

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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.

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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.

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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.

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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.

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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

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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

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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.

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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.

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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:

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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

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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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			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