Freshworks Q1: Downgrade To Hold Because Of Weak Near-Term Performance (2024)

Investment action

I recommended a buy rating for Freshworks (NASDAQ:FRSH) when I wrote about it in February this year, as I expected FRSH to continue growing, supported by strong execution and secular tailwinds. Since then, the stock has gone down by 35%, which was disappointing. Based on my current outlook and analysis, I downgraded to a hold rating. My key update to my thesis is that I was wrong about how the macro conditions would not have a major impact on FRSH. 1Q24 results showed that it does have a huge impact on customer growth, billing growth, and dollar retention rate. While there are good growth catalysts, I believe the market is going to focus on the near-term performance, and as such, it will be dependent on how the macro conditions play out. Given the weak near-term growth outlook, I have decided to take a more conservative approach.

Review

FRSH reported 1Q24 earnings on May 1, 2024. Revenue saw $165.1 million, representing 19.9% y/y growth. Non-GAAP gross margins did well, expanding by 230bps to 85.3%, coming in at $140.8 million. This led to non-GAAP EBIT margins expanding by a huge magnitude, from 2.8% in 1Q23 to 13.2% in 1Q24. As a result, non-GAAP EPS saw $0.09, a 300% increase from 1Q23. Free cash flow performance deserves a highlight too, as FRSH generated $38.7 million in FCF, representing a margin of 23.4%.

I have significantly underestimated how big the macro-impact would be on FRSH. In my previous post, I noted how well FRSH has been executing and that a 20% growth outlook is possible. Looking at 1Q24 results, my confidence has diminished. There are visible weaknesses across the board that made me revise my rating from buy to hold in the near term.

Firstly, reported billings growth of 14% y/y was a major disappointment as it marked an 800bps deceleration vs. 4Q23 growth of 22.1%. This is a major sign of weakness because billings growth and subscription revenue growth have a very high correlation and are typically leading indicators of future growth. We can see the obvious downtick in billings y/y growth in 1Q24, which led me to think that further revenue growth deceleration could be on the way. Management’s explanation for the slowdown is due to two reasons: (1) Lack of early renewal activity; and (2) FX. I believe both of these factors are driven by weak macro conditions (especially for the latter, which should continue to see pressure until customers gain more confidence in increasing budgets, which is dependent on the outlook of the economy) and are unlikely to recover anytime soon. Management even lowered billing expectations for the full year and now expects 16%, a full 250 bps downgrade from the prior guide’s midpoint.

Secondly, FRSH momentum in adding customers has also continued to slow, showing no signs of an uptick. Using FRSH’s reported end-of-period total customers, my analysis shows that sequential net adds have slowed to just 400 in 1Q24, a 5x decline from 1Q21, and a close to 4x decline from 1Q23 levels. This is another leading indicator of weak growth ahead. Lastly, net dollar retention [NDR] also saw headwinds, falling by 200bps to 106%. The weakness was mainly driven by the lack of large expansion deals that FRSH experienced in 4Q23, which I take as another major proof that the high rate environment is sinking its teeth into FRSH’s customer base.

That said, there are two positive medium-to-long-term growth catalysts that are worth mentioning, and I think they will help FRSH drive growth acceleration once the current macro situation ends. The first is the Copilot rollout. According to management, they are seeing traction across the customer base of all sizes in both consumption-based (bot) and seat-based (co-pilot) models. The key metric that made me very positive on this is that users are seeing 30%+ improvements in productivity, which gives me confidence that FRSH will continue to see more adoption.

The second is the FRSH acquisition of Device42 [D42] (expected to close in 2Q24 for $230 million). Given that the two companies have already been collaborating to co-sell each other's products to larger customers, I think FRSH will be able to reap many synergies from this acquisition. FRSH's win rates should improve after acquiring D42 because the company will be better positioned to compete with mid-market and enterprise clients. Furthermore, considering the companies' history of integration and the fact that the products already work well together thanks to previous co-selling activity, there should be no hiccups in integration. Since the majority of Freshservice's customers do not use D42 for IT asset management [ITAM], and the majority of D42 customers do not use Freshservice for IT service management [ITSM], there should be revenue synergies as well. This presents a natural opportunity for the expansion of both products.

Valuation

My new model’s price target has been shifted down drastically from ~$25 to $13 today, and I have higher confidence in the current model because there are visible headwinds with leading indicators that convince me near-term growth is going to remain weak. Below I give more details in my modelling thoughts.

I have shortened my model duration to focus on FY24 numbers as the market focus seems to be on the near-term (share price saw a big dip when management downgraded the growth guide for FY24). After reviewing the recent performance, I now believe FRSH is going to see weaker growth in FY24 as the weak macro conditions have a much bigger impact than I originally expected. To reflect this, I have downgraded my growth expectations from 20% to 17%, which is the low point of FY24 guidance.

FRSH currently trades at ~4x forward revenue, and while I believe this is too big of a discount relative to peers given that the growth disparity is not that huge—just a 300bps difference—but their multiple delta is ~5x, I believe the market is going to continue taking a very conservative view on the FRSH growth outlook as the growth could decelerate further depending on how long rates stay higher. Also, remember that billings growth saw a major downtick, which I believe is a leading indicator of further growth deceleration. Therefore, I attached 4x forward revenue to FRSH to value how much it is worth in the near term.

Risk

Upside risk is, of course, a recovery in macro conditions, which should drive demand recovery for FRSH, especially in smaller customers. The two growth catalysts that I have identified above may also start to contribute to growth much earlier than expected if management starts to monetize them, and depending on how aggressive the monetization strategy is, it could lead to huge growth acceleration.

Final thoughts

My recommendation is a downgrade from buy to hold due to a weaker near-term outlook. While 1Q24 results showed strong profitability metrics, revenue growth and customer metrics disappointed. Macroeconomic conditions had a larger impact than anticipated, leading to a slowdown in billings growth, customer adds, and net dollar retention. Although there are positive signs for the medium to long term, such as the Copilot rollout and the D42 acquisition, the market is likely to remain cautious due to the uncertain near-term outlook.

GS Investing