Freshworks: Investment In AI Serving As A Catalyst For Growth – Seeking Alpha

Summary

Readers may find my previous coverage via this link. My previous rating for Freshworks Inc. (NASDAQ:FRSH) was a buy, as FRSH was still demonstrating excellent execution and has reported significant FCF improvements. I am reiterating my buy rating for FRSH, as I believe its investment in AI and constant product innovation is going to not just retain existing clients but also attract new ones. With third quarter results showing strong growth in the double digits and management’s positive guidance also in the double digits, I am confident in FRSH’s outlook trajectory.

Valuation

Based on my view of the business, I anticipate a high double-digit growth rate for both FY23 and FY24. This projection is largely influenced by the management’s confidence, as shown in the full-year guidance provided during the earnings call. In the call, management guided revenue to grow in a double-digit range. I strongly believe FRSH will be able to achieve this figure given its robust third quarter performance, where its revenue grew at high double digit rates as well. Instead of just sitting on its current success, FRSH is always at the forefront of innovation by investing in AI and merging these capabilities into its products, which might open up future avenues for monetization. FRSH is also constantly developing and introducing new suites of products for not just existing clients but also to attract new clients.

Peers overview:

FRSH now trades at ~7.5x forward revenue, which is below the peer’s median of 8.65x. On a non-GAAP basis, FRSH’s gross margin is 83.7%, which is higher than the peer’s median of 80.77%. In terms of growth outlook, FRSH is in line with peers’ medians of 21%. On these grounds, I argue that FRSH should be trading in the peer’s range of 8.65x. At this level, my target price is ~$19, which implies a gain of 11%. Therefore, I continue to maintain my buy rating for the stock.

Comments

FRSH reported robust third-quarter 2023 results. Its revenue growth is impressive, as it reported $153.6 million, which translates to 19% year-over-year growth or 18% on a constant currency basis. In addition to revenue growth, its operating losses are shrinking as well. GAAP’s operating loss was $38.7 million, $19.6 million lower than last year’s loss of $58.3 million. When reported in non-GAAP, its non-GAAP operating income is $17.4 million vs. last year’s non-GAAP operating loss of $3.1 million. Since the start of the year, its non-GAAP EPS have turned positive, and they have been growing strongly. In the first quarter, its EPS was $0.03, but as of the third quarter, it was 0.08. This represents a growth of more than 2x, which is very impressive. A healthy $22.1 million in free cash flow was produced, and FRSH was able to raise its free cash flow margin to 14%.

In the current digital world, businesses must adapt and change in order to compete. Modern messaging is becoming the focal point of employee and customer experiences, and artificial intelligence [AI] is dismantling silos and providing richer insights that enable companies to learn much more about their workforce and clients. In order to extract more value from its current product suite, FRSH unveiled new generative AI capabilities across all of its products during the earnings call. Freddy Insights was the beta program that was launched after Freddy Self Service and Freddy Copilot in the prior quarter.

In my opinion, embedding AI capabilities across its products serves as a powerful growth driver for FRSH. With AI enhancements made to its products, FRSH is able to deliver more value to its customers. Therefore, with the same cost but with more features, it will definitely sit well with them. Once the customers are accustomed to FRSH’s SAAS services and form a bond and reliance on them, FRSH can start to monetize them without much backlash. During the earnings call, FRSH already had plans to monetize increased automation through bot sessions in a consumption or usage-based model.

Apart from AI, FRSH’s launch of its customer service suite back in August has been a great success and has received positive reactions. The customer service suite is an all-in-one solution to combine bots, modern messaging, and ticketing. During the first 2 months after the launch, over 200 new and existing customers of the customer service suite have signed up. In addition to its rapid take-up rate, higher levels of product engagement are also being observed than with Freshchat alone. The suite proved to be very popular not only with new clients but also with existing clients, such as a major US TV network and an upscale jewelry company that made the decision to sign up in order to take advantage of FRSH’s bot capabilities to expand self-service features. Fastway Couriers, a South African company that was among the first to use the customer service suite, delivers more than 16 million packages a year to a region that is almost twice the size of Texas. Overall, I expect its customer service suite and AI initiatives to be key growth drivers for FRSH’s future growth.

Looking ahead, I expect FRSH to continue on its strong growth trajectory, and this is in line with management’s expectations. Management guided revenue growth of 19% to 20% year over year, or between $593 million and $595.5 million. Overall, management’s guidance of high double-digit growth rates signals their confidence in the business. I also hold the same level of confidence, as I believe its AI initiatives and innovations will bring them to higher levels.

Risk & conclusion

One potential downside risk to my buy rating would be the intensely competitive nature of the SAAS market. If FRSH’s growth decelerates and fails to meet expectations due to market saturation, increased competition, losing in terms of innovation, or even general market uncertainty, which usually dampens tech spending, FRSH would see its valuation contract, which will lead to a lower share price.

In conclusion, FRSH’s third quarter results were outstanding and robust, as revenue and non-GAAP EPS continued to grow at high double-digit rates. As the world is rapidly advancing, FRSH is always at the forefront of innovation to capture these growths. They did so by investing in AI and adding these capabilities, which are in hot demand, to their existing products in a bid to create more value for their customers. On top of that, they are constantly innovating and creating new SAAS services for their clients. These new services are not a fluke and have reported strong growth and numbers. On the back of these drivers, it boosted management’s confidence, and they guided future revenue growth in the high double digits. With these factors, I maintain my buy rating for FRSH.