Freshworks Inc. Q2 FY2022 Earnings Call

Welcome to the Freshworks' Second Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. I would now like to hand the conference over to Vice President, Investor Relations, Joon Huh. Please go ahead.

Thank you. Good afternoon and welcome to Freshworks' second quarter 2022 earnings conference call. Joining me today are Girish Mathrubootham Freshworks' Chief Executive Officer; and Tyler Sloat Freshworks' Chief Financial Officer. The primary purpose of today's call is to provide you with information regarding our second quarter 2022 performance and our financial outlook for our third quarter and full year 2022. Some of our discussion and responses to your questions may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on Freshworks' current expectations and estimates about its business and industry, management's beliefs and certain assumptions made by the company as of the date hereof, all of which are subject to change. These statements are subject to risks, uncertainties, and assumptions that could cause actual results to differ materially from those projected in the forward-looking statements. For a discussion of material risks and other important factors that could affect our results, please refer to today's earnings release, our most recently filed Form 10-Q and other periodic filings with the SEC. Freshworks assumes no obligation to update any forward-looking statements to reflect events or circumstances that may arise after the date of this presentation, except as required by law. During the course of today's call, we will refer to certain non-GAAP financial measures, reconciliations between GAAP and non-GAAP financial measures are included in our earnings release for our second quarter 2022 results, which we issued earlier today and is available on our Investor Relations website at ir.freshworks.com. I encourage you to visit our investor relations site to access our earnings release, periodic SEC reports, a replay of today's call, or to learn more about Freshworks. And with that, let me turn it over to Girish.

Thank you, Joon and thank you everyone for joining us this afternoon. I will start the call with the recap of our results, then highlight our latest product updates and close with what we are seeing in the current market environment. Overall, we had a solid second quarter. We continue to grow efficiently and came in ahead of our expectations on both revenue and non-GAAP operating loss. Our Q2 revenue grew 40% year-over-year adjusting for constant currency or 37% on a reported basis. Our net dollar retention was 115% on a constant currency basis and it has remained steady in the 115% to 116% range over the last five quarters when looked at adjusted for constant currency. In Q2, we added nearly 1,800 net new customers. Angi Home Services, Cloudera, Sterling Bank, and Thomas Cook are just a few of the brands we are proud to work with. We also saw a healthy expansion rate among existing users and our multi-product adoption continues to climb. Today, 23% of our customers use more than one Freshworks product. Overall, I am really proud of our team and the progress we made in Q2, continuing our mission to deliver business software that people love to use. On the product front, let me start with Freshservice where continued demand in the mid-market is creating sustainable growth for our business. Companies like Toshiba, Dynatrace, and WD-40 are using our easy to use ITSM solution to support their global workforces. Our partners continue to contribute to our mid-market growth. One of our largest Freshservice deals this quarter was sourced by a regional channel partner in Africa, and this was closed alongside Device42, our technology partner for enterprise asset management that we announced last quarter. In Q2, we also strengthened our enterprise-grade IT operations management capabilities with enhanced alert management and on-call management features. Using these new Freshservice capabilities, a large bank in Southeast Asia, with nearly 4,000 employees, was able to cut down their IT-related alerts by approximately 60%. The bank's IT teams now use their time to resolve actual incidents rather than wasting time on thousands of false positive alerts. Freshservice saves our customers' time and money. We're also seeing customers expand their Freshservice usage to other departments for internal employee support. For example, AMEX Global Business Travel, the publicly listed global travel management company, uses Freshservice for both their IT and HR departments to deliver exceptional support to over 13,000 employees. We are proud to help companies of all sizes create a great employee experience with Freshservice. Now, let's shift to the customer side of the business where conversational engagement is a key part of our strategy to help companies reach and retain their customers wherever they are. In Q2, we brought back our Freshchat brand, previously known as Freshdesk Messaging, to better communicate our ability to create a seamless, conversational experience combining bots and live agent experience for our customers. With Freshchat, businesses can use bots to automate the first level of transactional support and gracefully hand over to a human agent for more complex use cases without sacrificing customer experience. Freshchat is a strong first entry point into consumer companies who often expand to Freshdesk or Freshmarketer. After the launch of CRM for e-commerce in Q1, we took our conversational engagement strategy a step further by re-architecting our standalone Freshchat product to work on top of our unified customer record platform, or UCR, along with Freshsales and Freshmarketer. Today, brands sell more and more through digital channels, and their customers expect instant support on third-party messaging apps like WhatsApp or Apple Business Chat, for example. With the addition of Freshchat to the UCR, we can now sell to marketing, sales or support organizations first, and then expand into the other departments by showcasing the power of unified customer communications. Our new platform also gives us the flexibility to quickly add on messaging channels. In Q2, we added integrations for Instagram and Google Business Messages. Enabling conversational messaging across multiple channels is creating new growth opportunities for us and our customers. A leading digital bank and payments company, with millions of customers and a long-time Freshworks customer, expanded their use of Freshchat in Q2, increasing overall customer satisfaction. Thousands of agents are now armed with live messaging capabilities that go beyond the website to provide customers with a seamless experience across iMessage and the mobile app. Conversational messaging capabilities are also important for our B2B customers. In Q2, we built new Freshdesk Omnichannel integrations with telephony providers like Five9 to optimize agent productivity when supporting customers across chat, email, social, and voice seamlessly. A new integration with workforce management software company, Injixo, also helps larger companies better manage their contact center team staffing, scheduling, and workloads. Thomas Cook, a popular global travel company, has a customer operations team of 80 people responsible for managing over 20,000 contacts every week. Workforce management features integrated with Freshdesk enables Thomas Cook to forecast team workloads and schedule the right number of support agents to provide a great customer experience throughout the year. Companies of all sizes are realizing the importance of streamlining and automating customer communications across all channels to help customer-facing sales, marketing, and support teams understand and serve their customers better. I am confident that our vision of a unified customer record and the progress we have made in Q2 will provide long-term growth opportunities for Freshworks going forward. Overall, we had a solid quarter despite the changing macro environment. So, let me talk about what we are seeing in the market. In Europe, we are pleased that we improved our execution and achieved higher close rates compared to Q1. We continue to monitor the region as it feels the pressure of rising inflation and an ongoing war. Among our global customer base, we are seeing a varying degree of impact across segments. Our SMB customers are feeling the macro pressures, and we are seeing this translate to higher churn, especially at the lower end of SMB, in companies with fewer than 50 employees. In contrast, our larger customers in the mid-market enterprise are showing more resilience, and they continue to grow their investment with us. As our business has moved more upmarket, our largest customers today represent the majority of our business at approximately 57% of our ARR. As a result, our overall churn rates for the company were roughly the same quarter-over-quarter as the higher SMB churn was offset by improvement in mid-market and enterprise segments. Additionally, we are seeing steady increases in the average revenue per account, reflecting our ongoing customer expansion and larger deal sizes. We have a global business with a very diverse customer base across multiple products and industries. In an environment where companies are spending more conservatively, I'm confident that Freshworks' affordable products will continue to deliver incredible value to our customers around the world and continue our long-term growth. With that, over to you, Tyler.

Thanks, Gi, and thanks to all of you for joining on the call and via webcast. As Gi mentioned, we're pleased with our solid execution in the second quarter. We maintained our strong expansion motion, with 115% net dollar retention adjusting for constant currency while adding new business and customers across our three broad product categories in customer support, sales and marketing, and ITSM. Although the negative impacts from FX increased throughout the quarter, we beat expectations for revenue, non-GAAP operating loss, and billings growth in Q2, demonstrating the resiliency of our business model in a changing macro environment. In fact, Q2 revenue growth would have been approximately 1% higher if currency rates remained the same from our Q1 earnings call. With FX volatility increasing over the past several quarters, I'll spend more time on the call today talking about constant currency comparisons both year-over-year and compared to our prior estimates last quarter. So, you'll get a better view of our underlying business fundamentals. As I normally do, I'll review our financial results from the recent quarter, provide background on key metrics, and close with our expectations for the upcoming quarter Q3 and full year 2022. I'll focus most of my financial results discussion around non-GAAP numbers, which exclude the impact of stock-based compensation and related expenses, payroll taxes on employee stock transactions, amortization of acquired intangibles, and other adjustments. So, starting with the income statement. Revenue grew 40%, adjusting for constant currency or 37% as reported to $121.4 million in Q2. We maintained a healthy expansion rate for our products, similar to Q1, with additional agent receipts being the largest driver of this expansion. We're also seeing a steady increase in our multi-product adoption, up 1% again to 23%. These customers now represent nearly half of our business. From a product line perspective, Freshservice continues to deliver strong growth and was the largest contributor to ARR growth in the quarter. We maintained steady non-GAAP gross margins at 82%, which was in line with the prior quarter and continues to be at robust levels as we scale the business. In Q2, non-GAAP operating expenses increased to $115.4 million. As we mentioned last time, our annual merit cycle takes effect during the second quarter each year, resulting in higher personnel costs. And this drove the majority of the increase in all three expense categories. Additionally, for sales and marketing, we had increases in travel activity, field marketing initiatives, and in-person events, including our Global Jam event, which contributed to the higher expenses quarter-over-quarter. As you would expect, rising inflation resulted in elevated supply costs and travel expenses for the business. Our revenue beat, combined with effective cost management, led to a non-GAAP operating loss of $15.8 million and $1.7 million ahead of our expectations for Q2. So, I'm pleased with our ability to execute toward our financial goals in the current market. Moving to our operating metrics. Net dollar retention was 111% and 115% on a constant currency basis in the quarter. The consistency of net dollar retention, or NDR, adjusting for constant currency, over the past five quarters reflects the ongoing expansion activity in the business and also our ability to effectively manage churn over this time. Now as we look forward into Q3, we expect FX rates and a slowing economy to impact our overall expansion rates, resulting in a reported NDR ticking down to about 110%. Turning to our customer metrics. Customers contributing more than $5,000 in ARR grew 22% to 16,212 in the quarter, and continues to represent 86% of our ARR. With a meaningful number of customers falling below the threshold of $5,000 in ARR because of FX moves, we're also providing the growth of this metric on a constant currency basis for Q2, which was 25% year-over-year. For larger customers contributing more than $50,000 in ARR, this customer count grew 42% to 1,648 and now represents 43% of our ARR. Adjusting for currency, this customer cohort grew at 48%. Lastly, our total customers grew to over 59,900 with a net add of nearly 1,800 customers in Q2 as our average revenue per account continued to increase in the quarter. Turning to billings. Q2 calculated billings outperformed our expectations as this metric grew 33% year-over-year, despite a negative 5% impact from FX movements. Other factors also impacting this growth rate include billing duration mix and reserve activity, each at positive 1%. Adjusting for these factors, our normalized calculated billings growth rate was approximately 36% in Q2, up slightly from the prior quarter. Given that calculated billings growth can fluctuate quarterly due to these factors, we're providing a preliminary view for Q3 billings. We estimate our reported calculated billings to grow approximately 25% in Q3. Moving to our balance sheet and cash items. We ended the quarter with cash and marketable securities of approximately $1.2 billion, similar to the prior quarter. Free cash flow was negative $10.2 million for Q2 and in line with our expectations. We continue to net settle vested equity amounts and used approximately $18 million under financing activities for Q2. As a reminder, this financing activity is excluded from free cash flow. We expect to continue net settling vested equity amounts for the foreseeable future, resulting in quarterly cash usage of approximately $16 million at current stock price levels. For free cash flow expectations, we are maintaining our prior estimates. We expect free cash flow to be negative $20 million for the full year of 2022, with estimates of negative $10 million for Q3 and slightly positive for Q4. We feel good about our cash balance, and we are well-positioned for durable growth. We expect to use less than 2% of our cash balance this year and reach positive free cash flow by Q4 with no debt. We have a strong balance sheet and an improving financial model and will continue to drive operating efficiencies as we scale the business. Looking at our share count for the quarter. We have approximately 322 million shares outstanding on a fully diluted basis using the treasury method as of June 30, 2022. The fully diluted calculation consists of 286 million shares outstanding at approximately $36 million related to unvested RCUs and PRCs. Now turning to our forward-looking estimates. Let me go through the numbers initially, and I'll provide background commentary afterward. For the third quarter of 2022, we expect revenue to be in the range of $124.5 million to $126.5 million, growing 29% to 31% year-over-year. Adjusting for constant currency, this reflects growth from 31% to 33% year-over-year. Non-GAAP loss from operations to be in the range of $14.5 million to $12.5 million, and non-GAAP net loss per share to be in the range of $0.07 to $0.05, assuming weighted average shares outstanding of approximately 286.7 million. For the full year 2022, we expect revenue to be in the range of $493 million to $497 million, growing 33% to 34% year-over-year. Adjusting for constant currency, this reflects growth of 35% to 36% year-over-year. Non-GAAP loss from operations to be in the range of $42.5 million to $38.5 million, and non-GAAP net loss per share to be in the range of $0.18 to $0.16, assuming weighted average outstanding shares of approximately 284.6 million. These estimates are based on FX rates as of July 29, 2022. As you know, we're trying to provide our best view of the business as of today and have taken into account all of the following items in arriving at our estimates. A few notable items to keep in mind. First, on FX. We have approximately 25% of revenue exposure related to the euro and British pound. As the dollar has strengthened versus these currencies, this has resulted in a negative impact of approximately $4 million to our full year 2022 revenue compared to our previously provided estimates. Second, on Europe. While we improved our execution quarter-over-quarter with higher close rates and productivity from our field teams, this region is feeling a greater impact from the current macroeconomic environment. Third, on SMB. Smaller customers are feeling the macro pressures, so we're seeing slower growth in this segment, especially on the very low-end of SMB. We are planning for similar trends in the second half of the year. And fourth, on operating loss. We are maintaining our operating loss estimates for the full year. While we may see higher costs in certain areas, we plan to manage the business overall to deliver on our efficiency goals for the year. Let me close by saying we delivered very solid quarter results in Q2. We are delivering real value to our customers with our products in this changing macroeconomic environment, and we remain confident in our long-term growth opportunities. And with that, let us take your questions.

Our first question comes from Brad Sills of Bank of America. Brad Sills, your line is open.

Great. Hey guys. Thanks for taking my question. Wanted to ask on the macro impact. You talked about in the very small segment of the business seeing some churn there potentially, and that's factored into some slow growth there factored into the guide. What about in the upmarket business? It sounds like you had some real good results there, that enterprise customer cohort growth at 25% constant currency, holding very nicely there. How much of that would you attribute to the effort to move upmarket, some productivity and some of the hires you've had? So, just a two-part question there. One, how is the productivity ramp in the enterprise going? And then two, any macro that you're seeing impacting in the enterprise and very small end of the market?

So, thanks Brad. This is Girish. I'll take this question. So, broadly, I think macro seems to be impacting all businesses, right? But as we called out specifically, we are continuing to see demand. And the mid-market and enterprise is continuing to expand and grow with us. So, in the really lower end of the SMB is where we saw increased churn. Conversations continue with customers where people are talking about being more conservative in their spending, etc. But overall, I think we've not done anything significantly new to close more enterprise deals or anything like that. We have both motions continue to grow. But I think we are seeing that our Freshservice business is actually more resilient. And the enterprise and mid-market larger customers are becoming more are resilient and we are seeing this across product lines as well.

That's great to hear. You mentioned Freshservice as a strong area for us, and I observed that you have added more modules, including project management, virtual agents, and SaaS management. Are you noticing customers entering the platform at a different point now that the ITSM and Freshservice suite has been expanded? Thank you.

So, we have all those modules, but we don't land with those modules. So, the value proposition of Freshservice is to have a unified product experience. So, the primary land is through ITSM, but the people use SaaS license management, project management. They're also planning to add on enterprise service management and ITOM, but we don't have separate land products for each one of those. In general, the land is through the unified product.

Thanks so much.

Thank you.

Thank you. Our next question comes from the line of Keith Weiss of Morgan Stanley. Keith Weiss, your line is open.

Thank you for taking my question. This is actually Ryan Bressner on for Keith. Maybe just first quickly, can we just dive into your comments about multi-product adoption? You called that about 23%, I think, of customers are doing multi-product. How do you view that moving forward? Is the risk that as IT budgets come under greater scrutiny that continues maybe to see headwinds, or will that accelerate as customers try to consolidate spend with their vendors? Thank you.

Thanks Ryan. Tyler, do you want to take this?

I can take that, Ryan. This is Tyler. So, just a commentary. We've just seen a steady progression in that multi-product number. I mean, it picked up 1% this past quarter from 22%, and it's just steadily been growing. And I just think it's a factor mainly of customers landing. They are adopting just like, as Gi said, additional products, right? A lot of it is coming from our omnichannel solution still on our Freshdesk side, but we're starting to see it now on the ITSM side as well as we add new modules that people can adopt. We don't see macro pressures actually slowing that down. We would actually see probably the opposite; if we're entrenched there, we will continue to see more adoption of those products. The expansion motions on agents is where we would probably see more pressure, right? If companies aren't adding more employees, then that's where we would see the pressure on the expansion side.

Got it. Thank you. Maybe just one quick. When you speak of the weakness in Europe, is that something consolidated in that region? Or has it started to spread into other areas yet?

Sure, I can take that, Ryan. In Europe, we're experiencing a more significant macroeconomic impact compared to other regions, particularly North America and EMEA, which includes Asia-Pacific, the Middle East, and Africa. The effects are not uniform across all areas. Additionally, due to the ongoing conflict and currency fluctuations, we noticed that our teams performed better compared to the previous quarter, closing larger deals and achieving higher conversion rates. Nevertheless, we are keeping a close eye on the situation, as the macroeconomic challenges in Europe are more severe than in other areas, and we have incorporated this into our guidance.

Got it. Very helpful. Thank you.

Thank you. Our next question comes from the line of Patrick Walravens of JMP Securities. Please go ahead, Patrick Walravens.

Great. Thank you. Hey, Gi, do you guys price your products in dollars? I mean, if I'm buying Freshworks in France, are the prices listed in dollars or in euros?

So, for euros and the British pound, we deal with multiple currencies, particularly the larger ones that we are exposed to, which include the dollar and GDP in Europe.

Pat, we have about 25% of revenue exposure to euro and pound.

Yeah. So it just confused me.

Yeah. I think the sites will have you land based on where you are logging in from.

Okay. So, here's my real question. So, my real question is, we all understand that the impact of the stronger dollar in terms of the difference between constant currency growth and reported revenue growth. What I'm wondering is, is the stronger dollar resulting in an effective price increase for customers, let's say, in EMEA? And does that affect the price increase reduce the demand for your products?

No, not necessarily, because that would be true if we had a dollar price and we were constantly adjusting the euro and pound based on that dollar price, right? But our euro and pound prices have stayed consistent, right? So, to the customers there, the price looks the same, except as we translate it back, obviously, we're getting less USD for it.

Okay. Great. Thank you.

Thanks, Pat.

Thank you. Our next question comes from the line of Brian Peterson of Raymond James. Brian Peterson, your question, please.

Hi, gentlemen. Thanks for taking the question. So, first one, I want to follow-up on a prior comment on the number of seats or users. As we're thinking about the macro this year, I know there's a lot of moving parts in ARR. Is that something that you guys have seen broadly across your customer base yet? Or how do we think about that trend line as we get through 2022?

Our expansion efforts continue to be influenced mainly by the number of agents and seats available. Additionally, our cross-selling initiatives contribute positively, as do customers upgrading their usage of the product. Looking ahead to the latter half of the year, we found that half of the revenue adjustments were due to foreign exchange factors, while the other half were linked to macroeconomic conditions. We are noticing some pressures on expansion. For instance, if companies aren't hiring, we would expect them to refrain from adding more agents, which aligns with our expectations. Therefore, we anticipate some challenges on the expansion front.

Understood. Thanks, Tyler. As a follow-up, I'm interested in the situation in Europe, which seems to be improving. Considering the linearity throughout the quarter, are there any trends you would highlight for this quarter and what you've observed in July so far? Thank you.

We're not providing comments on July specifically or the quarter beyond the guidance we've issued. Today, we're discussing our expectations based on what we know at this moment. Generally, in Europe, there are several factors at play, but there is also a historical trend of seasonality during the summer months, and we're observing that pattern as well.

Thanks Tyler.

Thank you. Our next question comes from Pinjalim Bora of J.P. Morgan. Your line is open. Go ahead, Pinjalim Bora.

Thank you. Hey, guys. Congrats on the quarter. Girish, on Freshchat and overall on the unified customer architecture, it seems like you have now three products kind of architected that way. What are you hearing from customers on that point? Is that a big factor that people are kind of clinging on to? And when do we see Freshdesk, I guess? Is that the plan as well to be that re-architected under the unified customer architecture?

Thanks, Pinjalim. Yes, that is indeed the direction we are pursuing. Our vision for the customer segment of the business revolves around helping businesses gain a comprehensive understanding of their customers. With the recent transition of the standalone Freshchat product to the UCR platform, we now have marketing, sales, conversational support, and bots all integrated into a unified customer record. We are also focused on migrating Freshdesk, our largest business, to the platform. We will provide updates on that as it progresses, but it remains a key priority for us.

Thank you for your response. I have a question for Tyler regarding the billings guidance for the next quarter. It appears there's a significant decrease in expectations, dropping from 33 to 25 in USD. Can you help clarify the assumptions behind this? It seems like you're anticipating around a one-point headwind for the next quarter, potentially with a bigger impact from foreign exchange on DR. Are there any other factors you're considering? For example, are you expecting close rates to decline sequentially going into Q3? Please help us understand this deceleration better.

We have discussed the broader economic factors impacting our business. On the small and medium-sized business front, we've noticed a slight increase in churn, which affects our billings. We're being cautious as we approach the European market. The 25% figure mentioned refers to our reported numbers. Each quarter, we make various adjustments because we don't consider billings an accurate reflection of our performance due to inherent volatility. These adjustments typically account for foreign exchange effects, reserve changes, and duration activity. The figures we can provide are based on what we currently observe in the system and historical trends, although these estimations aren't always precise; this represents our initial outlook.

Just so I understand, are you expecting the macro environment to deteriorate from what you saw in Q2 in that billings number?

Well, I think what we're saying is that the macro environment has continued to move against us since last quarter. The small and medium business sector is feeling the impact from three to six months ago. Europe remains somewhat uncertain. We are incorporating all of these factors into our guidance.

Got it. Thank you very much.

Thank you. Our next question comes from Alex Zukin of Wolf Research. Alex Zukin, your line is open.

Hey, guys. You got Allen on for Alex Zukin. Thank you for taking the question. Glad to see execution improvement in the quarter. I was wondering if you could call out specifically maybe the top things that you saw improved in the quarter. A quarter ago, we were talking about some of the go-to-market issues in Europe and so forth. So, I want to start with that. I have a quick follow-up. Thanks.

Yeah. I'll take that. So, I think specifically on Europe, we invested last quarter, as we said, in ongoing training and sales enablement of our reps. So, all of that is on track. And we saw that translate into better execution, resulting in higher conversion rates in the field in Q2 when compared to Q1. We are continuing to ramp and improve productivity in the field. Specifically on the other areas of improvement, I think we are also looking at what are the more efficient places in which we could channel investments like, for example, we are looking at investing more in Freshservice for the short-term as it brings more mid-market customers. So, that's an area that we are currently working on. So, we are closely monitoring the region and the macro. And because we are multi-product, we have the ability to kind of adjust the levers that we have with our control and control the spend accordingly.

Got it. Thank you. And just as a quick follow-up. I wanted to touch on gross retention. Understanding that gross retention, as you called out, seeing more pressure in that sub 50 cohort. And this has been something that's kind of been in the region of high teens, low 20s. Can you just talk about how that was for your over 50 employee cohort and maybe the overall business relative to the prior quarter? Thanks.

We haven't provided a breakdown of the churn rate by cohorts, but our overall churn rate for the company is in the high teens. We have seen an increase in churn particularly among small and medium-sized businesses, notably worse within the 0 to 50 employee segment. However, our mid-market enterprise business has shown more resilience, offsetting the negative effects of that churn, so our overall churn rates have remained relatively stable.

Thank you.

Thanks, Allen.

Thank you. Our next question comes from the line of DJ Hynes of Canaccord. DJ Hynes, your question, please.

Hey, this is Luke on for DJ. Thanks for taking the question. So, I'm curious, in a recessionary environment, do you change your go-to-market or marketing playbook at all whether that's prioritizing certain product messaging around ROI and time to value or specific product use cases?

Sure. I'll take that. So, first of all, I'd like to start off by saying one of the key value propositions of Freshworks is that we are not just easy to use and easy to set up, but we are also more affordable compared to expensive enterprise vendors. And anecdotally, we have seen that businesses come to us when they want to save costs. So, now having said that, as we look at the recessionary environment and as we look at the different parts of our business, we are clearly seeing areas where we could channel our investments better. And one such area is clearly – like we are clearly looking at ITSM as one area where we could invest more. Conversational engagement is another. So, we are prioritizing our go-to-market investments for the short-term. Longer term, our priorities haven't changed because we believe that there is enough growth left in each of our three large markets.

Got it. That's great to hear. And then just quickly on the billing guidance for Q3. Does that assume a different exchange rate or currency impact relative to what you saw in Q2?

No. No. We kind of assume the same.

Thank you. Our next question comes from Brent Bracelin of Piper Sandler. Brent Bracelin, please go ahead.

Good afternoon. Thanks for taking the question. And I actually had three topics I wanted to touch base on, churn, competition, and cash. Let's start with churn. I know you talked about kind of seeing an uptick in churn. But if I look at the mix of the business relative to, let's say, SMB, while it's 70% plus of the logos, it's only 14% of ARR. So, as you think about churn in the smaller customer cohort, how much would that actually impact the overall revenue if it's only less than 15% of this from a revenue perspective? I guess, the impact of logos, but it doesn't feel like it could be a huge material impact unless you saw churn creep up in the mid-market large enterprise space.

Yeah. So, one thing, Brent, is that the stratification of the greater than $5,000 and the greater than $50,000 customers doesn't necessarily align with what we define as SMB and the mid-market enterprise. So, we definitely have SMB customers to us who are 100 to 250-employee businesses. And we definitely have customers in there that are paying us greater than $50,000. So, it's not quite aligned that way. Now of our ARR base that we would say is SMB, it's just over that 40% number. And in that, yes, we are seeing a little bit of the churn pick up a little bit. And then what we highlighted is in that 1 to 50, which is kind of the low-end of SMB, it's even a little bit more. That being said, you're right that the broad – the majority of our ARR is coming from that mid-market enterprise, and that base has remained really resilient and is kind of offsetting any negative pressure right now that we're seeing from the SMB side.

Got it. So, think of SMB as representing just over 40% of the ARR base, and it's really in this area where we're beginning to notice increased churn. That's very helpful information. Regarding competition, as the environment becomes challenging, some private companies we compete with may face funding issues, and there are larger competitors undergoing acquisitions. Are you observing any irrational behavior in the competitive landscape, whether in pricing or discounting on large deals? I'm curious if you've noticed any unusual activities, whether positive or negative, from competitors in the past three months.

I'll take that, Brent. I think nothing much has changed. It is similar to prior quarters. If you look at why people choose us over the competition, it remains the same: rapid time to value, ease of use, easy onboarding, and more affordable pricing. We actually have some recent wins that are encouraging, especially in the customer experience space. Additionally, we've noticed that larger enterprise vendors are reporting longer sales cycles, but we're not experiencing that. However, I want to point out that we are not seeing any irrational behavior from privately funded companies yet. So, nothing new.

Okay. That's helpful color. And then last question here. You're in the enviable position to have over $1 billion of cash and investments. Obviously, if I think about the track record of the business, you've been generating positive free cash flow in fiscal 2020. In 2021, it looks like you'll burn a little bit of cash flow this year. So, you're not going to consume much of that $1 billion in cash that you have. So, what's the plan as you think about the current environment, valuation reset? What are the plans to put some of that cash to use to either broaden the product portfolio? Would you consider kind of M&A as a path to accelerate product development? I love to better understand how you view that $1 billion in cash as a strategic opportunity to enhance the business. Thanks.

We have a clear plan for our product portfolio and a corporate development team that actively seeks out potential opportunities. Given that private market valuations are extremely high, it may take some time for founders to adjust to the new pricing. However, we are not rushing into anything. We will continue to explore opportunities and might consider any that provide a technological or go-to-market advantage. We are not focused on acquiring for the sake of revenue; instead, we are looking for strong teams, technology, or market advantages. Generally, we are not pursuing large acquisitions.

Totally makes sense. Appreciate the color on those three topics. Thank you.

Our next question comes from the line of Brent Thill of Jefferies. Brent Thill, your line is open.

On Europe, you mentioned the execution improved. I'm curious if you strip out the macro and just rated the execution now. Are you back to 80%, 90%? Or are you still at 70%? How would you characterize your health meter in the European execution excluding the macro? That's it. Thanks.

Hi Brent, it's Tyler. We're really pleased with our conversion rates in Q2; they are significantly better than in Q1. In Q1, we did mention some deals that we didn’t close and that hindered our performance. This is why we attributed it to execution issues. However, in Q2, our conversion rates improved greatly. Additionally, we have noticed a decrease in attrition, which will help us ramp up our representatives more quickly. Overall, we feel confident about our execution at this time. That said, it's difficult to isolate all the factors, especially regarding broader macroeconomic conditions. Therefore, we are continuing to highlight challenges in Europe, which is still experiencing some pressure.

Thanks Tyler.

Thank you. Our next question comes from the line of Ryan MacWilliams of Barclays. Ryan MacWilliams, please go ahead.

Thanks for taking the question. So, you mentioned your expansion motion primarily being driven by seats. Is there any more color you can give around the net retention split between seats versus cross-sell? And if this has shifted over time as you build out your product suite. Thanks.

We haven't detailed the specific percentages related to the sources of our expansion, but the majority comes from agent and seat expansion. That's still the largest contributor. Cross-sell is next, followed by additional upgrades.

All right. That's it for me. Thanks.

Okay.

Thank you. Our next question comes from Scott Berg of Needham. Scott Berg, your line is open.

Hi, Gi and Tyler. Congrats on a really nice quarter.

Thanks Scott.

I guess want to just kind of a follow-up to, I think Brent's question on the competitive environment. You had a competitor in the service desk environment. Recently, you have taken private. Obviously, the transaction has not closed yet, but how do you think about those opportunities? Obviously, it's a well-known vendor in the space. I'm sure we're all familiar through it is, but do you get some new opportunities or gains to new opportunities as that transaction progresses?

So, Scott, we have always been competing with Zendesk. In nearly every deal, we go head-to-head, and most of the time, customers have not reacted significantly. However, recently we experienced two encouraging wins, both in the FinTech space, with deals exceeding 50k. We are starting to see some progress. We hope that if they are taken private, we are doing everything possible to execute better and continue to win.

I appreciate the assistance. Tyler, my follow-up question pertains to a topic I've heard from several shareholders over the past couple of months regarding share-based compensation and what to expect moving forward. This concern arises from current stock prices and other company-specific factors. In the last quarter, share-based compensation as a percentage of revenues was around 40%, which is higher than what is typically seen in the SaaS industry. Do you anticipate that this will decrease to what is considered a normal range for the industry, or do you expect it to remain elevated for an extended period? Thank you.

We expect it to trend down over time. We incurred expenses from grants last year and this year, which we're amortizing over a four-year period. Therefore, this expense will continue for the foreseeable future. However, we do anticipate that it will eventually decrease.

Great. That's all I have. Congrats on a really good quarter.

Thanks, Scott.

Thank you. Our final question comes from the line of Nick Altmann of Scotiabank. Nick Altmann, your line is open.

Great. Thanks guys. Just to kind of go back to some of the go-to-market tweaks you alluded to. Just given the strength you're seeing in the mid-market with Freshservice, I'm just wondering if you could put maybe a finer point on the go-to-market tweaks there as you start to lean in some of the stronger. Is it allocating more reps to the U.S.? Is it allocating more reps away from SMB to the mid-market? Just if you could put a little bit of a finer point on that, I think that would be super helpful. Thanks.

Sure. Let me address the question and welcome Nick to the Freshworks coverage. Regarding Freshservice, we are definitely focusing more on it in the long term. Specifically, we are looking at what we can do in the short term, primarily through increased digital spending. This approach will help us enhance our short-term results since generating a pipeline for mid-market enterprise deals can take one or two quarters. We are employing a mix of strategies, but our main priority, in addition to the R&D investments we've made this year, is to explore opportunities in the digital SMB segment for Freshservice. Thanks.

Thanks, Nick.

Thank you. At this time, I'd like to turn the call back over to Freshworks for closing remarks.

Great. Thank you so much for joining us. If you have any questions, please feel free to reach out, and we'll talk to you next time. Thank you.

This concludes today's conference call. Thank you for participating, and you may now disconnect.