After having a subpar customer experience a decade ago, Freshworks CEO Girish Mathrubootham built a tool to help businesses better manage and centralize their customer interactions. In this episode of Industry Focus: Tech, we talk about the company's torrid growth and the competition it might face from the big dogs.
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This video was recorded on Sept. 10, 2021.
Dylan Lewis: It's Friday, Sept. 10, and we're talking about a fresh S-1. I'm your host, Dylan Lewis, and I'm joined by Fool.com's frugal fountain of free-flowing Foolish philosophies, Brian Feroldi. Brian, how're you doing?
Brian Feroldi: Dylan, I survived my first week of sending my kids back to school. Everybody has a smile on their face, so I'm in a great mood. How are you, Dylan?
Lewis: You look cheery. We're taping this within our member livestream, Motley Fool Live. You don't look down at all because of that. You look like you have survived and you're thriving, Brian.
Feroldi: My secret is that I do yoga right before I come on Industry Focus, and that always puts me in a good mood.
Lewis: It's amazing what a stretch will do for you. You're going to work the body out and make sure everything feels like it's being used. Yeah, I'm doing well. I'm excited. We have an S-1 show here, always one of my favorite things to do. In this case, we have to give a shout-out. We got this company recommended to us from @IrritableInvestor on Twitter, and the company is Freshworks, which I'm sure we will make many puns on throughout the show, if history is any indication. Pretty interesting business, Brian. This is a relatively fresh prospectus that we're looking at. It has not been out that long.
Feroldi: When I first learned about this company, this is a company focused on customer relationship management tools. I thought, another one? That was my initial thought about this company. There are so many wonderful tools out there that do this exact same thing. Just off the top of my head, I was like, Salesforce.com, HubSpot, Zendesk, Appian. How on earth could this company possibly be different?
Lewis: Yes. We will get into the magic quadrant for the company in this space that this company operates in. It is a crowded one for sure. Maybe we'll just go straight into the S-1 and go from the company writing here on describing themselves. They say: "We provide businesses of all sizes with modern SaaS products that are designed with the user in mind. We started with Freshdesk, our customer experience product, then later expanded our offering to include Freshservice, our IT service management products, and expanded our product offering to include more complete customer relationship management solutions, which includes salesforce and marketing automation." It gives you a pretty good lens into what we're talking about here. Yeah, Brian, those are some pretty crowded product categories already.
Feroldi: They certainly are. But just digging into the quick history of this company, it does show signs that the company is clearly thinking with optionality in mind. As you pointed out, they started out with just a product that was focused on the consumer experience. But they have clearly entered other product categories, so they now have five total product categories, most of which are paid products, but they do have some tools that are downloadable for free. They have Freshdesk, which is their flagship product, which is a messaging service, customer contact service, customer success services, etc. They have Freshsales, which are tools focused on the needs of sales professionals; Freshmarketer, which is marketing tools; Freshteam, which is tools for HR departments; and Freshservice, which is for the IT service department. They are really focused on providing a ton of back-office tools for businesses.
Lewis: Yeah. This is one of those classic founder story-type businesses. The CEO and CTO are founders, started by Girish Mathrubootham. You'll see him referred to as "G" sometimes, as he is in the founder letter in the prospectus. And then there's Shan Krishnasamy. They founded the company over a decade ago, after G had run into issues where a TV was broken during transit and he had made a very vocal and ultimately viral post about it looking for some customer service help. The experience for him identified that, and you have to go back in time here. This is 2010; it's quaint to think about. Companies need to be able to interact with customers in a lot of different avenues, increasingly. with the advent of social media in particular, Brian, users are far more in control of that dynamic than they used to be.
Feroldi: There's no doubt that the tools that this company's offers are a must-have for businesses nowadays. Hosting them in the cloud just offers so many advantages. To your point, one customer can go out and get on social media these days and really create a bad PR fiasco for you. Having the tools in place to manage the customer relationships throughout the entire experience is crucial.
Lewis: It's an interesting business in the tech landscape, because it was founded in Chennai, in India. It is headquartered in San Mateo. For folks that are going to be interested in watching this one, the proposed ticker is FRSH. Just some details to keep in mind here, Brian, even in describing what the company does in the prospectus, we use the non-proper-noun version of a company. We brought "sales force" into the conversation, but we were using it in the literal sense -- lowercase "s," space, lowercase "f." Sales force. There's no shortage of companies that are interested in this space, and it's a big part of how the company even talks about themselves.
Feroldi: I really like that, because right up front in the shareholder letter from the CEO and founder to potential investors, they acknowledged all of the questions that I initially had about the business when I first heard about it. I love this quote: "Freshworks is the company that wasn't supposed to win. Whether we could differentiate ourselves in a crowded market or compete with larger players, or built a global SaaS company from India, the doubts were always there and people were not shy about telling me this over the years." I really like that honesty up front. Yet despite those headwinds and my initial hesitation about the company, the numbers clearly show that this company is winning.
Lewis: It reminds me in a way, I think it was Jack Dorsey who wrote a 100-plus-point rundown of all the reasons that Square could fail when he was building Square, or maybe before he built Square. It reminds me of that. You want the humility of someone who has been told this isn't going to work and then goes out and says "I think I'm going to do it anyway." So far it has proven to be the right decision, 100%, for the management team and the founding team here. They are surprisingly large for a company that operates in a space with so many big players already.
Feroldi: They have already attracted more than 52,000 customers in total. That number is growing at a rate of about 2,000 or so per quarter. While many of those customers are small businesses and medium-sized businesses, they do have over 13,000 customers in total that will spend more than $5,000 per year on this platform, and they have 1,100 companies that are going to spend $50,000 per year on this platform. That includes companies that undoubtedly our listeners have heard of: Discover, Coupa Software, American Express, Tailor Made, Stitch Fix. While the vast majority of their customers are small and medium-sized businesses, they have landed some relatively big customers, too.
Lewis: Yeah. I think in talking through what the company does in the space that it operates in, no one's going to be surprised here when we talk about the business model, Brian, this is pretty typical SaaS.
Feroldi: It is a software-as-a-service business model. You can just stop there, pretty much, but they do offer some free tools to get people interested and on board up front. Those free tools are mostly about website monitoring and incident management. From there, if they can grab your email address, they do try to upsell you to their many other services. We listed them before. In addition to that, they have a growing network of industry partners that can help to onboard customers. They have more than 400 of these partners in place around the globe, and they also have a thriving app store. Once you get on top of this product, you can easily shop and add other products and services from the companies, and build their marketplace. They have over 1,000 apps and integrations, including Slack, Jira, Shopify, Zoom, Mailchimp, etc.
Lewis: That's a playbook that we have seen a lot of other larger companies hit, and it's been incredibly successful.
Feroldi: That's right. The company does have the numbers to show that its growth strategy is clearly paying off. The numbers that we do have so far for fiscal year 2020, total revenue was up 44% to $250 million. You look one line below that, and we see a 79% gross margin. High growth, high gross margin -- pretty good start so far. On the bottom line, the company reported an operating loss of about $50 million. In 2020, they were producing an operating loss. If you push forward to the first half of 2020, the numbers actually get better. Growth so far in the first half of 2020 was about 53%, so a slight acceleration sequentially.
One thing to note is this company is losing money on the bottom line, but that is almost entirely due to their largest spending category, which is sales and marketing. They spend about 54% of total revenue on sales and marketing. That makes sense, given how crowded the space is. However, on a free cash flow basis, the company is already free cash flow positive, generating about $4 million in the first half of 2021.
Lewis: Just to clarify that, Brian, I think you might have this right, but it's the first half of 2021, we saw some growth in revenue acceleration. You might have said 2020 in there. I just want to make sure we got that right for our listeners. But what I think is interesting is if you look at the costs here, sales and marketing, a huge part of it. We see R&D is also a relatively sizable part of it. Slimmer losses in 2021 so far than what we saw in 2020 for this business. A big part of that is a reduction in R&D and SG&A spend.
We know that customer acquisition is a really large part of how software companies grow. Very often you have to pay to acquire those customers. We'll have to keep an eye on that. But if you're looking holistically at the financials, it is a company that's moving closer and closer to profitability. You love to see that a business that has already achieved relatively decent size can find accelerating revenue growth.
Feroldi: That's rare, especially in the crowded marketplace. Again, because of the competition here, it makes sense if they do have to spend so heavily on sales and marketing. It's also worth pointing out that this company has pretty high stock-based compensation costs. It's common for us to see low stock-based compensation expense prior to going public. Then those numbers really accelerate after they come public, and that really gives you a true sense of what stock-based compensation looks like.
For the first half of 2021, this company actually reported stock-based compensation expense of $42 million. I'm sure a whole bunch of that is the reason why expenses grew so much in sales and marketing and in R&D. We don't have proof of this yet, but it's possible that dilution here could be pretty high post-IPO.
Lewis: You never know. It's just one of those big things you just got to wait and see. I think one thing that is reassuring, looking at the financials, too, is you go over the balance sheet -- over $100 million in cash as of the end of June of 2021. The biggest line item, when you look over their liabilities, is deferred revenue. Looking around, Brian, I didn't really see much in the way of long-term debt for this business. Not that it's something that has to be there for me, but it's always encouraging to know that there's a lot of financial flexibility there.
Feroldi: For sure. The balance sheet prior to coming public looked good. Obviously, it's only going to look better post-IPO. From that perspective, the company's in good shape.
Lewis: This is a SaaS company, so no surprise, we're going to look beyond the standard financial metrics here and look at some industry-specific ones. Brian, we're going to start out with net dollar expansion rate, or, in this case, retention rate.
Feroldi: That's the good one. That does include churn, and as of the most recent quarter, that figure was 118%. That is actually a pretty impressive figure, given the companies that this business tends to serve. As a reminder, they have about 52,000 total customers, but only about 13,000 of them are spending $5,000 or more. That tells me that probably around 40,000 are likely to be small businesses. When you are catering to the needs of small businesses, one downside is churn tends to be higher. The chances of those companies going out of business is higher the chances of them being more willing to give up your service based on price or getting bought out. That's just the nature of the market that they're in. The fact that their dollar-based net revenue retention was 118% is pretty good when put in that context.
Lewis: I think it's easy with the market environment that we've been in recently to say, oh, it's only 118%. Our meter has been broken a little bit by some business, Brian. A hundred and eighteen percent is pretty stellar. Apps and everything else, we're getting pretty solid growth even if they don't bring new customers in.
Feroldi: It's also important, just the nature of the business model. This is a subscription-based business model. A lot of the numbers that we've seen that are completely eye-popping are usage-based business models like Snowflake, for example. Like Twilio, for example. That dynamic alone changes the nature of the dollar-based net revenue retention rate. Again, 118% in the most recent quarter might not jump out at the page, like wow, look at that number. But judged in the context of being subscription and servicing small customers, it's solid.
Lewis: I think one of the benefits of serving small customers is, you're a little bit more insulated from competition. We know that they are operating in the credit space, where there are a lot of very big players out there. Being a relatively accessible option and being a place where some of the smaller fish are going to come, it's probably a little bit less competitive there. Additionally, there is the opportunity, Brian, it's like having an unmonetized free audience if you're in the freemium model where a very small percentage of their customers or relatively small percentage of their customers are spending more than $5,000 in ARR. That means that there's a very large opportunity in front of them if they are able to grow with their customers and be able to build them into larger accounts going forward.
Feroldi: For sure. The company also breaks out another spending category. Customers that will spend more than $50,000 per year or more on this platform, that figure was 1,164. That minority of customers -- again, that's only what, about 2% of their total customers -- that 2% of customers account for about 33% of total annualized recurring revenue. We do see, while they do have lots of customers in total, a minority of customers are driving an outsize portion of revenue. Thankfully, even with that dynamic, there is zero customer concentration risk here for investors to worry about.
Lewis: Yeah. Folks who listen to the show regularly know we like to look over at what type of moat a business has. That'll be the next thing we'll check out here. I think similar to most SaaS companies, Brian, it's sticky once you're in there. I think the challenge is for a company like this -- I'm going to sound like one of the people in the founder's letter here -- they are actually going up against a lot of other companies' moats. They have to convince people to choose their solution over some of the deeper, more entrenched legacy solutions.
Feroldi: That's the nature of really a lot of SaaS companies that we've talked about. It is often very hard and very expensive to acquire those customers. But once you do acquire those customers, they tend to get used to your product and they are loath to switch to another one. If you just look at this company's net revenue retention rate, that clearly proves the company is keeping the lion's share of the customers that it does acquire.
But to your point, make no mistake -- this company is facing off against some huge competitors right up front when it is trying to get those new customers in the door. They're facing off against Salesforce, Pegasystems, ServiceNow, Zendesk, Microsoft, Oracle, HubSpot, so the company does have its work cut out for it.
Lewis: It does, and I think it's interesting to look at that magic quadrant we cited often when we're looking at various software categories. This comes from Gartner, and it's a decent lens into how people are looking at the industry. Takes a look at both business' ability to execute and the completeness of that company's vision. Salesforce is far and away the leader in the CRM customer engagement center market. They run that market.
Then there's a cluster of other companies. You mentioned a bunch of them -- Microsoft, ServiceNow, Zendesk, Oracle, Pegasystems. Freshworks, I would say, is in the middle of the pack for this market, and they're going to have to prove for a lot of the larger accounts they want to bring on that they offer something unique that a lot of these other players, especially, some bigger enterprises are probably using already.
Feroldi: One of the ways that they say that they differentiate themselves against the likes of those industry titans they're going up against is ease of use. I personally used Salesforce.com in the last company that I worked for, and I can tell you why. It was extremely powerful. It was not intuitive. It did take a bunch of training to get up and running. I'm sure that's changed dramatically in the 10 years since I last used it, but I'd buy that when they say the company, if you're using a service from Oracle or Salesforce, they're designed for bigger organizations that have a certain type of dynamic at the company. Freshworks is going after the smaller companies, and they said that they compete on ease of use, completeness of products, and lower total cost of ownership, so that's how they are separating themselves.
Lewis: I will add, staring at the magic quadrant here, Freshworks is the only one in the visionary category, and they've been there twice. They're six consecutive years in the quadrant. They are certainly on the map, and I think they are just meeting a slightly different section of the market right now than a lot of those bigger names out there, and probably offering a really compelling solution to a lot of these small and medium-sized businesses.
Feroldi: Well, we don't have to really guess at that. We just look at the numbers, and they've got 50,000 customers and they're attracting 2,000 more. Their strategy is clearly doing something right.
Lewis: Yeah. When we turn over to TAM and potential here, Brian, no surprise, big numbers. We're talking software. We're talking a relatively aggressive growth company. The numbers get big fast. They're eyeing a $120 billion TAM. Even if you get a healthy haircut on that, there's no shortage of opportunity here.
Feroldi: Yeah. They believe that of the $125 billion total TAM, the number that is addressable today is about $77 billion. That's the magic of really anything to do with cloud computing. Not only is the absolute size of the market enormous today; they're growing at a very healthy rate. Yet again, if this company doesn't succeed, it's not because the opportunity isn't there.
Lewis: I mentioned that two founders are still at the helm here as the CEO and CTO. Pretty high marks. We talked about just the nature of the founder's letter, and I was really impressed by that. But what we see when we look over at Glassdoor, seems like there's pretty steady approval of the CEO. People enjoy working at this business. I think they have 4,000 employees, Brian. This is one of the companies that is sneaky big.
Feroldi: It is. It's much bigger than you would assume that it is, and I'm guessing a whole bunch of them are in sales and marketing to get people in the door and onboarding. But Glassdoor definitely checks out here. The company itself gets 4.3 stars out of five, the CEO gets a 97% approval rating, and that is on almost 500 reviews, so that is likely to be an accurate representation of what it's like to work at the company.
Lewis: Putting it all together, Brian, taking it all in, this is a space that you and I both invest in a lot. We both own a good number of SaaS players. In some ways, this looks like a pretty typical, smaller SaaS business. We know what is ahead of them. They need to convince companies to spend with them instead of spending elsewhere. They don't have the benefit of creating a market and being the first entering in it, which I think is one of the easier ways to go about being a SaaS company.
Feroldi: Yeah. If you take everything all together, I think that there is more to like about this business than there is to dislike. The SaaS business model is obviously one of our favorites. Customers are clearly very sticky, as shown by that dollar-based net revenue retention rate. There's already signs of optionality and launching new products and new services. It's a founder-led business with a great corporate culture. They're already free cash flow positive, their balance sheet is in great shape, they're growing strong, and their TAM is absolutely huge.
Offsetting that awesomeness is the fact that this is a highly competitive market and is only likely to get even more competitive moving forward. The company has to spend a ton on customer acquisition to bring those customers in the door. Once again, this is a company that's choosing when it needs to go public. The idea here isn't we need capital; we have to go public. It's we want to go public. Because of that, it could indicate that growth may be slowing.
What does growth look like in a post-COVID world? We don't know that yet. We also don't know things like what does inside ownership look like post-IPO? How much money are they raising? What's the valuation? But overall, I think this company does check many of the boxes that I look for.
Lewis: Yeah, and valuations are going to be a bit easier. It was a $3.5 billion company in a 2019 funding round off the much smaller revenue base. We have to work to something based on both the revenue, growth, prospects in general, but I think you can expect it to be a pretty large number when it comes public. This is not going to be a company that's debuting at sub-$5 billion.
Feroldi: Yeah, high-gross margin, high-growth is just going to be a $6 billion company, $8 billion company, $9 billion company, $20 billion company? Who knows what the market is going to end up paying for that. That will be something for investors to watch.
Lewis: Yeah. But with a net dollar retention rate as high as they have and pretty solid top-line growth, certainly an interesting business. Brian, for me, a watchlist stock, mostly because I just want to see what they're able to do. It's a cool tech story as well, just knowing that the founding story and everything like that, and so this is a watchlist one for me.
Feroldi: Yeah, I'm right there with you. It's a watchlist one for me. Not one I'm going to be foaming at the mouth to buy on day one, but if the price came along that I was looking for and the company proved itself out as a public company, I could see it take up a position down the road.
Lewis: Shout out to @IrritableInvestor for throwing this one on our radar, and we are always looking for ideas for the show, Brian. Brian, you are @BrianFeroldi on Twitter; we are @MFIndustryFocus on Twitter. Feel free to shoot your ideas there, and of course, [email protected] is another spot where you can send potential show topics.
Brian, yesterday was our 2,000th episode of Industry Focus, and one person was left off of the thanks and gratitude, and I think it was you. I don't know if you've got name-checked. We spent so much time hitting on all of the folks from the history of the show. I love doing the show with you, man, and it's really a joy to do it with you.
Feroldi: Well, that means that if yesterday was a 2,000th, that means that me and you got the 1,999th and the 2,001st, so take that, the rest of Industry Focus.
Lewis: That's right. Yeah, our poor Industry Focus listeners have gotten me three times this week. I think they're ready for a palate cleanser on Monday with Jason Moser. Brian, as always, I hope you have an awesome weekend. Thank you so much for joining me on today's show.
Feroldi: Thanks, Dylan. I love being here.
Lewis: Listeners, that's going to do it for this episode of Industry Focus. If you're looking for more of our stuff, subscribe on iTunes, Spotify, or wherever you get your podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for all his work behind the glass today, and thank you for listening. Until next time, Fool on.
