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Freshworks: On A Downward Spiral

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Thesis

If you clasp Freshworks (NASDAQ:FRSH), aliases if you scheme connected buying it, I impulse you to publication this article first. I judge Freshworks is simply a very mediocre SaaS institution pinch a broken business model:

  1. Growth metrics are weakening
  2. Guidance implies further slowdown ahead
  3. Real profitability is obscurity successful sight

Growth metrics are weakening

Freshworks hit statement estimates connected revenues by 1.9% successful Q4 FY22. However a look astatine nan broader gross maturation inclination shows a clear slowdown:

Revenue maturation YoY

Revenue maturation YoY (Company Filings, Author's Analysis)

From a accordant maturation complaint supra 40%, nan company's maturation floor plan has steadily degraded to 26.3% YoY growth.

Revenue maturation QoQ

Revenue maturation QoQ (Company Filings, Author's Analysis)

The quarterly maturation trends illuminate further weakness; nan mean of nan past 3 quarters' QoQ maturation rates connote an yearly maturation complaint tracking astatine 22%; a 4% increment beneath what nan yearly maturation numbers are presently showing. Note really nan 3.4% QoQ maturation people successful Q4 FY22 is nan weakest nan institution has seen complete nan past 15 quarters.

A cardinal logic for these slowing maturation trends is nan company's struggles successful up-selling and cross-selling its customers. Management admitted successful nan Q4 FY22 net telephone that they expect further slowness successful materialization of relationship description efforts. The nett dollar retention rates quantify a company's recurring revenues per account, which is nan core engine of a SaaS business specified arsenic Freshworks.

Net dollar retention

Net dollar retention (Company Filings, Author's Analysis)

A dependable diminution successful nett dollar retention suggests from 118% to 108% suggests that not only is Freshworks struggling to up-sell and cross-sell to customers, but that it is connected a downward way to making little money per relationship arsenic well. CFO Tyler Sloat called retired that this diminution will proceed successful Q1 FY23, pinch expectations of a further crisp diminution successful nett dollar retention to 105% connected a changeless rate basis:

Looking ahead, arsenic we expect nan broader inclination to continue, we estimate Q1 2023 changeless rate nett dollar retention to beryllium 107% and holding FX rates constant, reported nett dollar retention to beryllium 105%.

As an aside, nan institution is presently facing a class-action suit for alleged deficiency of transparency pinch investors during its IPO successful September 2021. The crux of nan lawsuit for nan suit is nan following:

The alleged mendacious and misleading statements and omissions include, but are not constricted to, that: (i) astatine nan clip of nan IPO, nan Company possessed accusation showing that its gross maturation and billings were decelerating (ii) astatine nan clip of nan IPO, nan Company’s nett dollar retention complaint had stalled; and (iii) arsenic a consequence of nan foregoing, nan Company’s Offering Documents were materially mendacious and misleading astatine each applicable times.

I will not estimate connected nan result of nan lawsuit; however, I see this to beryllium a motion of perchance mediocre firm governance.

Guidance implies further slowdown ahead

Management is guiding for a 15-18% YoY maturation for FY23. Now billings are a starring parameter of revenues. In Q4 FY22, normalized billings maturation came successful astatine 29% YoY:

Billings maturation YoY

Billings maturation YoY (Company Filings, Author's Analysis)

So contempt nan starring parameter signaling 30%, guidance is still guiding for a 15-18% YoY maturation for FY23. Reading betwixt nan lines to reconcile these information points, I infer that guidance is anticipating a much prolonged downturn successful 2023. Indeed, successful nan latest net call, CFO Tyler Sloat conceded that:

We really expect it to proceed to beryllium reliable for a while, and we've built that in.

Real profitability is obscurity successful sight

The astir concerning point astir Freshworks is not nan maturation but nan profitability. Real profitability, including banal based compensation costs, is obscurity adjacent to nan horizon.

GAAP EBIT margin

GAAP EBIT separator (Company Filings, Author's Analysis)

The institution is consistently making adjacent to 46% EBIT separator losses. I americium amazed that location is very small talk astir this fact. These profoundly unprofitable margins is owed to a precocious level of banal based compensation expenses:

Stock based compensation arsenic % of revenue

Stock based compensation arsenic % of gross (Company Filings, Author's Analysis)

Stock based compensation is taxing Freshworks much than 40% of revenues each 4th since nan IPO. But erstwhile nan institution reports successful adjusted profit terms, excluding banal based compensation costs, it paints a very rosy image astir a progressing way toward profitability:

Adjusted EBIT margin

Adjusted EBIT separator (Company Filings, Author's Analysis)

However, this rosy image does not bespeak nan economical reality of nan business. Stock based compensation is simply a existent operating costs to nan business. Even if nary rate technically changes hands, costs successful banal should beryllium considered arsenic a rate balanced since that worth is still leaving nan company. The 'Dean of Valuation', Professor Aswath Damodaran explains it amended than maine successful this station connected really to treat banal based compensation.

Furthermore, contempt a maturation complaint of supra 25% astatine nan very least, location is virtually zero operating leverage since nan company's IPO. This is mostly owed to income and trading costs remaining astatine 55% level for donkey's years:

Sales and trading costs arsenic % of revenue

Sales and trading costs arsenic % of gross (Company Filings, Author's Analysis)

Considering nan degrading nett dollar retention trends, nan deficiency of operating leverage connected income and trading costs implies inefficient customer acquisition costs to clasp and get customers. Freshworks inability to make separator benefits from gross standard makes it a mediocre package institution that fails to meet nan Rule of 40, moreover erstwhile 1 generously uses adjusted margins successful nan competition:

Rule of 40 Metric

Rule of 40 Metric (Company Filings, Author's Analysis)

Freshworks' sum of its yearly maturation complaint and adjusted EBIT margin, which includes banal based compensation scores good beneath nan 40% that is emblematic of high value package companies.

Takeaway

Overall, Freshworks is connected a downward spiral. Revenue maturation and nett dollar retention has been slowing down gradually and indications are that location is further weakness ahead. But astir importantly, nan institution is profoundly unprofitable pinch much than 40% operating nonaccomplishment margins, pinch nan inclusion of nan very existent banal based compensation costs. Additionally, nan deficiency of immoderate operating leverage successful income and trading costs complete nan past 16 quarters highlights a mediocre business exemplary incapable to modulation to genuine profitability.

Therefore, if I were a shareholder, I would waste FRSH stock.

This article was written by

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Disclosure: I/we person nary stock, action aliases akin derivative position successful immoderate of nan companies mentioned, and nary plans to initiate immoderate specified positions wrong nan adjacent 72 hours. I wrote this article myself, and it expresses my ain opinions. I americium not receiving compensation for it (other than from Seeking Alpha). I person nary business narration pinch immoderate institution whose banal is mentioned successful this article.

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