Freshworks Inc. Q2 FY2023 Earnings Call

Hello and thank you for standing by. Welcome to the Freshworks' Second Quarter 2023 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 call over to Joon Huh.

Thank you. Good afternoon and welcome to Freshworks' second quarter 2023 earnings conference call. Joining me today are Girish Mathrubootham, Freshworks' Chief Executive Officer; Dennis Woodside, Freshworks' President; and Tyler Sloat, Freshworks' Chief Financial Officer. The primary purpose of today's call is to provide you with information regarding our second quarter 2023 performance and our financial outlook for our third quarter and full year 2023. 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, including our financial outlook, macroeconomic uncertainties, management's beliefs and certain other assumptions made by the company, 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. Such risks include but are not limited to, our ability to sustain our growth, to innovate, to meet customer demand and to control costs and improve operating efficiency. 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-K and Form 10-Q and our other periodic filings with SEC. Freshworks assumes no obligation to update any forward-looking statements in order to reflect events or circumstances that may arise after the date of this call, 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 for historical periods are included in our earnings release, which is available on our Investor Relations website. I encourage you to visit our Investor Relations site to access our earnings release, supplemental earnings slides, 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 welcome everyone. Thank you for joining us today on Freshworks earnings call covering our second quarter of 2023. We delivered a strong Q2 and outperformed our estimates across all our key financial metrics. Our revenue exceeded the high-end of our financial outlook range coming in at $145.1 million for the quarter. We continue to improve our business efficiency leading to free cash flow of $18.1 million, significantly surpassing our expectations. I'm really proud of our team effort this quarter. We made a number of operational changes at the beginning of the year to go after larger customers and target a more profitable segment of the market and we are starting to see the benefits in our results. As a reminder, we have included these financial highlights in the supplemental earnings slides on our Investor Relations website. We will also hold our first investor day on September 7 in San Francisco. I look forward to seeing you there. Now I'll get into our business drivers beginning with product innovation. In June, we showcased our Freddy AI strategy, introducing new generative AI capabilities that can be used across product lines. First, is Freddy Self-service, which helps businesses offer personalized customer and employee service with conversational bots. Next is Freddy Copilot, which is a personal assistant that works like an always-on AI collaborator, offering contextual information and insight and offloading repetitive tasks. And finally, with Freddy Insights, we are leveraging AI to provide even more proactive insights and recommendations through a conversational interface. All three Freddy AI capabilities can help IT professionals, salespeople, marketers and support agents work more efficiently. Powered by Freddy AI, our self-service experience including fresh bots for CX and virtual agents in IT assisted customers in more than 220 million interactions in Q2. Later this week, we will be introducing new pricing for our AI-powered bots which enables us to monetize our enhanced capabilities as we create value for our customers. In addition, we plan to introduce at a later date a Freddy Copilot add-on that provides access to our AI capabilities, starting at a price of $29 per agent per month. Our goal is to put the power of AI in the hands of as many customer and employee-facing teams as possible. With respect to our customer service business, we will be launching our Freshworks customer service suite also later this week. This is our first solution built from the ground up with Freddy AI. The modern multi-channel customer service suite brings together the power of AI advancements to conversational support and ticketing all in one offering, and we believe it is the future of customer service. This will provide customers with automated self-service across channels and is expected to supercharge agent productivity and deliver proactive insights for leaders. We are proud to be opening this up to our customers in the next few days. Turning to our ITSM business with Freshservice, we continue to deliver capabilities that make employee experiences better and empower organizations to provide them efficiently and reliably. We are also extending the capabilities of Freddy AI to Freshservice. It now provides conversational self-service in the employee's language of choice, including German, French, and Spanish. After launching Freshservice for business teams in December of 2022, we continue to see validation of our initial thesis of a large market demand. Nearly one out of every five new accounts are adopting Freshservice for business themes for non-IT functions on their initial purchase. One of our customers, PitchBook, offers financial research and insights to capital market professionals. They were trying to make another well-known provider's solution work, but it was cumbersome and not suited for their IT infrastructure and objectives. Since going live with Freshservice for their IT facilities and RevOps department, PitchBook has decreased agent response and requested wait times by over 20% and automated IT processes for employee onboarding and offboarding. In our CRM business, we remain focused on delivering a sales and marketing solution powered by AI that helps teams message sharper, engage better, sell smarter, and close deals faster. Within Freshsales, we have improved how sellers operate and engage with customers by integrating generative AI across key modules, Freddy Copilot provides support throughout the sales process. This frees them to focus on building relationships and closing deals. Within Freshmarketer, we are leveraging generative AI to help marketers gain insights into customer behavior, preferences and purchase patterns and launch highly personalized campaigns. In Q2, we released our integration with WooCommerce, which allows millions of store owners to get access to our Freshmarketer solution. In Q2, we also announced Freddy Copilot for developers applying generative AI to the neo platform and enabling a faster app development experience. In some instances, Freddy Copilot has cut developer time from nine to ten weeks to less than a week. We also launched the Global apps framework to enable developers to publish a single marketplace app that can work across multiple Freshworks products. That is expected to provide developers faster time to market, less overhead of managing and building apps and better integrations across Freshworks products. In the last few months, we've made significant advancements in generative AI for our customers. And we plan to continue to leverage our efficiency and scale to bring these accessible solutions to companies of all sizes. Before I hand it over to Dennis, I'm pleased to announce the recent appointment of Frank Pelzer to our Board of Directors. Frank is currently the Executive Vice President and Chief Financial Officer of F5 Inc., and the former President and Chief Operating Officer of the cloud business group at SAP. I'm excited to add his tremendous experience building and scaling global cloud software companies to the Freshworks board. Now over to Dennis, who will detail how our changes in GTM have positively impacted our business.

Thanks, G and thank you everyone. We appreciate you joining us for today's call. As you can see in our Q2 results, we're starting to realize some of the benefits of the strategic go-to-market decisions we made earlier this year. We are seeing that our actions that set us on a path to win bigger deals, expand within existing accounts, and improve our operating efficiency are working to drive profitable growth for Freshworks. In January, we shifted our field teams to focus on landing bigger customers and this quarter, we began to see the results. In Q2, Freshworks customers paying us over $50,000 in ARR grew 33% year-over-year, up from the 30% growth we saw in Q1. This customer cohort now represents 46% of our ARR as larger customers are fueling the growth of our business. Recent examples include a large American consumer product company, a famous British car company, a well-known Japanese tech conglomerate, and Clopay Corporation. Clopay is North America's leading garage door manufacturer and came to Freshworks to improve customer engagement. The increasing multi-channel interactions with garage door dealers through calls, mobile chats, website forms, and physical walk-ins necessitated a unified platform for a better agent and customer experience. Clopay chose Freshdesk, Freshchat and Freshcolor to achieve this and continues to see significant customer service benefits. Also in January, we solidified teams dedicated to ensuring our customers succeed and grow with us. We are seeing results from that change in Q2. Of our net customer adds over $50,000 in ARR, the majority is coming from expansion. Our net expansion for our mid-market and enterprise accounts was 12%, which is well above the average rate for the company. Our average realized price per seat for ITSM for which we issued price changes in January increased by 4%, and our multiproduct adoption rate increased in Q2, rounding up to 25%. A great example is Trainline, an international digital rail and coach technology platform serving train riders in 45 countries. Demand from U.S. travelers doubled the downloads of the Trainline app in just 1 year, and they relied on Freshdesk and Freshchat for their customer service needs. In Q2, Trainline's Partner Solutions team expanded their usage and adopted Freshservice to manage their partners' experience, citing improved time to value as the main deciding factor. An example of seed expansion is a leading American steel company. After acquiring 12 companies in 5 years, this manufacturer selected Freshservice for one business unit and has consistently replaced legacy vendors one after the next, with another Freshservice instance year after year. We've grown from 250 to 600 agents, providing them excellent time to value as they centralize IT workflows and govern multiple business units more efficiently. In the first half of 2023, we made several tactical changes to how we go-to-market to acquire higher-performing customers efficiently. These changes have had a positive impact on our business. First, we adjusted our marketing budget to overweight the acquisition of larger, higher potential customers. This contributed to an overall improvement in efficiency, demonstrated by non-GAAP sales and marketing as a percentage of revenue going from 51% in Q1 to 48% in Q2. Second, we expanded our free offering for Freshsales products for a number of months to test and attract a larger pool of future paying customers at lower marketing costs. We recently discontinued this expanded free test as we continue to optimize our offerings. But as a related consequence of both of those tactical changes, we added fewer customers spending less than $5,000 in ARR in Q2. Third, we purposely moved more new customers from monthly and quarterly contracts to annual and multiyear agreements. This trend towards annual contracts contributed to our Q2 calculated billings growth increasing quarter-over-quarter. We ended the quarter with more than 65,600 total customers, including Claremont McKenna College, in the State of Hawaii, Johns Hopkins, and Dave & Buster's. While we added a lower number of customers compared to prior quarters, we increased ARPA and kept dollar base churn relatively stable. We're confident that intentionally going after larger deals is creating a stronger and healthier base of customers to grow from in future quarters. All of these changes are helping drive further efficiencies in the business and improve profitability. Now over to Tyler to go through the financial details.

Thanks, Dennis, and thanks again to everyone for joining us. Once again, we had a strong quarter in Q2. We beat our revenue growth estimates and created significant leverage in the business to expand both non-GAAP operating and free cash flow margins by 5 percentage points quarter-over-quarter. We are starting to realize the financial benefits resulting from the operational changes made earlier in the year, and we're creating a healthier foundation to position the business for profitable long-term growth. For our call today, I'll cover the Q2 financial results, provide background on the key metrics and close with our forward-looking commentary and expectations for Q3 and the full year 2023. I'll include constant currency comparisons for certain metrics to provide a better view of our business trends. And as a reminder, most of our discussion will be focused on non-GAAP financial results, which exclude the impact of stock-based compensation expenses and other adjustments. Starting with the income statement. Revenue grew 20% year-over-year, adjusting for constant currency. On an as-reported basis, revenue grew 19% to $145.1 million as we saw negative impacts on currency rates for the dollar against the euro and pound over the past year. New business strength in ITSM continued to drive much of the growth in Q2, while expansion rates overall ticked down slightly in the quarter. In Q2, our non-GAAP gross margins increased 1 percentage point quarter-over-quarter to 84% as a result of efficiency improvements in our infrastructure spend, AWS costs and other one-time items. Our non-GAAP operating expenses were relatively flat quarter-over-quarter and down more than $5 million year-over-year. The majority of the decrease year-over-year was driven by lower sales and marketing expenses of $4 million as we improved spend in our go-to-market efforts. This includes shifting focus towards a more durable, higher-yielding customer base. All of this led to a significant outperformance for non-GAAP operating profit of $11.7 million and a non-GAAP operating margin of 8% in Q2. Given the many changes we've made over the past year, I'm pleased with the tangible improvements we're making in our efficiency. Turning to our operating metrics. Net dollar retention was 108% in the quarter, which includes a 1 percentage point benefit from FX. In Q2, expansion growth was roughly in line with our expectations. Dollar-based churn performed better than our estimates, but slightly increased quarter-over-quarter. We are planning for the lower net expansion trends to largely continue and expect the net dollar retention rate to be in the 105% to 106% range on constant currency in the second half of the year. Moving to our other key operating metric, number of customers contributing more than $5,000 in ARR. This metric grew 18% year-over-year to 19,105 customers in the quarter and maintained a similar growth rate compared to the prior quarter. On a constant currency basis, this customer metric grew 17% year-over-year and now represents 88% of our ARR. For larger customers contributing more than $50,000 in ARR, this customer count growth improved to 33% year-over-year, with 2,186 customers and now represents 46% of our ARR. Adjusting for constant currency, this cohort grew at 32%. We added approximately 700 net customers in the quarter, which was lower than our historical quarterly figures. Nearly all of the difference was from the smaller customer cohort of less than $5,000 in ARR. Net adds for this cohort were impacted by the tactical changes that Dennis mentioned earlier as well as higher logo churn from smaller CX customers. We ended the quarter with a customer count of more than 65,600 and as we continued our focus on attracting larger customers, building a healthier base and driving a higher ARPA. Moving on to calculated billings, balance sheet and cash items. Calculated billings grew 22% year-over-year both on a constant currency and as-reported basis to $158.9 million. Factors including timing duration of contracts and revenue reserves in the quarter created a slight benefit, resulting in a normalized calculated billings growth of approximately 21%. Looking ahead to Q3 2023, our preliminary estimate for calculated billings growth is 18% as reported and 17% on a constant currency basis. For the full year 2023, we expect calculated billings growth to be similar to our expected annual growth rate of approximately 19% as reported and 19% on a constant currency basis. During the quarter, we generated over $18 million in free cash flow, significantly ahead of our estimates and reflective of the efficiency improvements we're making in the business. As a result, we added $10 million in cash, cash equivalents and marketable securities to end the quarter with a balance of $1.16 billion. We continue to net selling invested equity amounts using more than $15 million during the quarter, which is reflected in financing activities as this activity is excluded from free cash flow. We plan to continue net selling invested equity amounts resulting in Q3 cash usage of approximately $23 million using current stock price levels. Given the meaningful operational efficiencies we realized in the first half of the year, we are raising our free cash flow estimates for the full year 2023 to $60 million, with approximately $18 million and $15 million expected for Q3 and Q4, respectively. Turning to our share count for Q2. We had approximately 329 million shares outstanding on a fully diluted basis as of June 30, 2023. The fully diluted calculation consists of approximately 293 million shares outstanding, 34 million shares related to unvested RSUs and PRCs and 3 million shares related to outstanding options. Let me now provide our forward-looking estimates. For the third quarter of 2023, we expect revenue to be in the range of $149 million to $151.5 million, growing 16% to 18% year-over-year. Adjusting for constant currency, this reflects growth of 15% to 16% year-over-year. Non-GAAP income from operations to be in the range of $6 million to $9 million and non-GAAP net income per share to be in the range of $0.04 to $0.06, assuming weighted average shares outstanding of approximately 300.2 million shares. For the full year 2023, we expect revenue to be in the range of $587 million to $595 million, growing 18% to 19% year-over-year. Adjusting for constant currency, this reflects growth of 18% to 20% year-over-year. Non-GAAP income from operations to be in the range of $24 million to $32 million and non-GAAP net income per share to be in the range of $0.18 to $0.22, assuming weighted average shares outstanding of approximately 299.8 million. Given the U.S. dollar trends over the past year, we saw a slight negative impact to our growth rate in Q2. Our forward-looking estimates are based on FX rates as of July 28, 2023, so any future currency moves are not factored in. Let me close by saying, I'm pleased with our business performance in the first half of the year. Even though we made a number of changes to our go-to-market approach and business operations, the team continues to execute and manage through these changes to deliver on our growth targets for the business. We're starting to see some of the benefits from the changes as we improve our operating leverage and drive profitable growth. We plan to carry this business momentum into the second half of the year, and we remain excited as ever and look forward to our many opportunities ahead. With that, let us take your questions.

Thank you. Our first question comes from Brent Bracelin with Piper Sandler. Please proceed.

Thank you for taking the question. Good afternoon. It seems that the fundamentals here are stabilizing. Dennis, could you elaborate on the acceleration you noticed in the 50,000k cohort? It appears that the growth rate improved from 30% to 33%. Is this linked to some of the changes in your internal execution, or do you think there’s something else that is appealing to those larger customers about the product? Thanks.

Thanks for the question, Brent. So absolutely, we are starting to realize the benefits, a lot of the changes that we made back in January and that has enabled us to create an even stronger and healthier base of these larger customers to grow from. Our product has advanced at a very high rate over the last couple of years. If you look at the ITSM products specifically. We have ITSM, we have ITOM, we have ESM now. All those are resonating in the market, and our sellers are doing quite well. So we're getting more at that and we've just put more wood behind the not huge deals, but slightly larger deals and you're seeing that in the numbers for sure.

It comes from the line of Ryan MacWilliams with Barclays. Please proceed.

Hey, guys. Thanks for taking the question. Really excited to see the AI product announcements coming. Tyler, just on the contribution from the AI products and the new pricing. Are these contemplated in forward guidance? And I guess, how do you envision this layering into your model in the coming quarters or years? Thanks.

Hey, Ryan. Thanks for the question. So no, we actually haven't built in any upside from the products and the pricing changes that are coming forward because I think it is so early that we'll have to learn. But our guidance is essentially reflective of what we see today based on what we have and what we expect to sell without any upside from AI.

Great. And also pleased to see the strong profitability improvement in the quarter. What were some of the drivers there? And are there any changes in the head count materially contributed to this improvement? Thanks.

Yes, you're right. We're really excited about the kind of efficiency initiatives that we put in place at the beginning of the year and how those have played out. And we've always thought we've had leverage in the model and can feel like we continue to have leverage in the model, which we obviously built that into a lot of our guidance going forward. Headcount-wise, we haven't had to do anything dramatic. We've actually just been moving to kind of culture performance and everything else as we move forward and making sure we have the right people in the right places.

It comes from the line of Pinjalim Bora with JPMorgan. Please proceed.

Congrats on the quarter. One question on just maybe talk about your conversations with your customers about kind of appetite for AI and a Copilot, trying to understand how should we think of kind of the ramp or uptake of Freddy Copilot within the CX business? And how are you thinking of pricing kind of the other copilots and self-serve and insight tools?

Thank you for the question, Pinjalim. This is Girish. We are currently developing Freddy Copilot, which serves as an AI assistant for all our users, including customer service and sales personnel. We have several early adopter customers that we are collaborating with to see its capabilities in action. For instance, a shipping and postal company in New York is utilizing early features to generate replies and summarize queries for their customer service representatives. Additionally, we aim to ensure that the Copilot can automate routine manual tasks. We are enthusiastic about this, as we are working with over 2,000 early adopter customers. We plan to start monetizing the Copilot in the near future.

Interesting. Got it. Thanks. And on free cash flow, it seems like, if I remember that correctly, I think when you entered the year, it was about $10 million for the year and then you went to $20 million, now you're talking about $60 million. How much of that ramp is because of this change in duration towards annual?

Yes, I would say not that impacted. It does have a little bit of impact to our billings numbers. But the actual change in annual collections that's not really driving our operational kind of performance. A lot of it is around just prudence that we've had on the cost side and prudence around hiring. The duration billing is pretty nominal.

It comes from the line of Brian Peterson with Raymond James. Please proceed.

Congrats on the quarter. Just one for me. On AI and all the product announcements you have, I know there's a lot of in-market products that you're already selling today, but I'd love to understand on the sales and marketing front, as AI becomes more commonplace, do you think that changes kind of the medium-term ramp for those products as they build from where they are today? I hope I can get some perspective on that. Thanks guys.

Sure, Brian. I'll take that. This is a quick overview. We announced Freddy Self-service for customer and employee self-service, Freddy Copilot, which serves as an AI assistant for our users, and Freddy Insights for data-driven leaders. Our goal is to monetize the Freddy Self-service product through Freshbots when we launch our new customer service suite on August 3. We plan to price the copilot at $29 per agent, but monetization will come later. We are still collaborating with early adopter customers, and Freddy Insights will be introduced soon after.

It comes from the line of Patrick Walravens with JMP Securities. Please go ahead.

Congratulations on the second really good quarter in a row. So G, one area that I've been wondering a lot about is sort of the resources that you need to deliver generative AI solutions. So in particular, do you have enough sort of PhD level AI talent to design these? And then do you have access to the GPUs for the training?

We are indeed making those investments. While I can't provide an exact number of PhDs we have, we have AI leaders from Microsoft with extensive experience on our team. We're collaborating with various technology providers, including Azure and Open AI, among others. Additionally, we are in the process of investing in AI to develop domain-specific and customer-specific large language models. As part of this effort, we are considering establishing some AI labs in India, which is part of our plan.

Great. And what is the difficulty in accessing the GPU power needed to train these models?

Yes. I believe Satya Nadella mentioned that if there is a scarcity it could lead to disruption. This is one of the reasons we are looking to secure investments to ensure we have access to that. Some of our investors have also provided us with access to GPUs through their connections. Currently, we do not face a shortage, but we are all waiting to see how the situation unfolds in the future.

It comes from the line of DJ Hynes with Canaccord Genuity. Please proceed.

Tyler, I want to ask on the billings guide. So look, if my numbers are right, I think in Q1, it was 20% constant currency growth. This quarter improved to 21% normalized. I think you said you're guiding to 17% in Q3. I mean from all the qualitative, quantitative commentary, it sounds like you guys feel pretty good about business momentum. I'm just wondering if that's like typical prudence or are you seeing something in the business that would suggest things might slow again in Q3. Just any kind of high-level thoughts there would be helpful.

Yes. Thanks, DJ. No, we really are trying to call it as we see it. We don't see a slowdown per se. We did say that we expect net dollar retention to kind of come down to 105%, 106%. We had actually expected a little bit higher churn coming into the year. We didn't see it in Q1. Q2 ticked up slightly, but it actually was better than our expectations. We do still think there's going to be some continued pressure there, and that's why we're saying it's going to come down. And then the expansion motion, which we started talking about at the beginning of last year, is still seeing pressure. And so what we're trying to do is just call it as we see it, and then obviously, we will update it as we go along.

It comes from the line of Elizabeth Porter with Morgan Stanley. Please proceed.

I wanted to ask about the move upmarket and pricing, you guys have expanded the portfolio, which along with the go-to-market motion, has allowed you to be more successful upmarket. Yet pricing still largely balances being able to address both the low-end of customers and the high-end of customers. I know you called out price increases in ITSM. But just more broadly, how do you think about pricing as a lever as you focus more on upmarket customers? Thank you.

Thanks for the question, Elizabeth. We see pricing as a critical focus for us. We recently implemented one of our initial pricing adjustments this year in our IT suite, where we increased prices. As mentioned earlier, we achieved about a 4% price increase there. Our approach involves rolling out prices for new customers and then for those renewing. We're finding opportunities with renewing customers across all products to raise prices, especially for deals coming up for renewal that may have offered higher discounts than necessary, given the rapid advancements in our products and the value we're providing. This also helps us increase Average Revenue Per Account, which you can see reflected in the ARPA numbers. As we continue to enhance our approach to pricing based on value, we expect it to become an even greater lever for us moving forward. It’s definitely a priority for me, and we aim to maintain our competitive position in the market. We still enjoy a significant Total Cost of Ownership advantage over our competitors in terms of ticket prices and implementation costs. Therefore, we have room to adjust prices, and we want to handle any changes thoughtfully. We also see opportunities to be more strategic with pricing. For instance, we plan to price our AI add-on at about $29 per seat and will announce a revised pricing scheme for bots later this week that will enable us to monetize them at a higher rate.

It comes from the line of Taylor McGinnis with UBS. Please proceed.

So the billings performance relative to the guide was really solid. And if I adjust for days in the quarter, it looks like the sequential growth in the 3Q guide is roughly a point stronger than what you guided to in 2Q. I know that you said churn picked up a little. But I guess, how would you characterize the demand environment in June and July versus what we've seen previously? Are we starting to lap some of the rightsizing or slower expansion activity that could be helping? Are you seeing signs of improvement, or is it largely just driven by some of the sales changes you've made?

Yes. I think largely, it's gone along as we expected, Taylor. I mean, clearly, our guidance is taken into effect all the information we know right now. And so in terms of how the quarter is going, it's as expected. The guide, like I said earlier, we are really trying to call it as we see it. I think if you look at billings, it was impacted slightly by kind of a move to larger customers that tend to pay annually in advance. And specifically, our new business in Q2 was really strong, specifically with ITSM in the field motion. We would expect that to continue, but we built all that kind of into our guidance.

It comes from the line of Adam Bergere with Bank of America. Please proceed.

Can you expand on any differences you may be seeing in demand expansion or churn in front office versus back office solutions? For example, just comparing maybe the CRM business versus Freshservice. And then, also just thinking about front office versus back office, what do you think will have, which will AI have a greater value proposition for? Thanks.

One I start and then have G talk about some of the AI stuff. I think, generally speaking, let me just start kind of a little bit higher level. In terms of new business, we're seeing IT in particular, do very well. And I think that's partly because the product has come a long way. We've introduced ITOM ESM capabilities and a number of other aspects of functionality that makes the product really suitable for that solid mid-market business, which for us is about a 5,000 employee company. Our largest customers tend to be more of the customer service product set. And that's because we tend to have a lot more agents in a customer support team than you do over in IT. So we see quite a bit of expansion there. We are seeing, as we move into larger accounts, those larger accounts are expanding at higher rates than our smaller accounts, and that's also helping us drive or sustain the net expansion rate that we've seen. So I think the demand is slightly different than that. We are seeing very strong demand on the IT side. We're seeing more muted demand for new business on the CX side. We're seeing reasonable demand, I would say, on the expand motion for CX and IT is a newer product or newer, large installed base there, the expansion motion also is quite good with products like ESM, that gives us a whole new expansion motion for those customers. So that gives you a little bit of a flavor. And Gee, maybe you can talk about the AI stuff?

Yes. I'd quickly add, Adam, while we expect AI adoption and transformation across all products, I think the biggest change is going to come or the demand is going to come from customers self-service in the front office.

It comes from the line of Alex Zukin with Wolfe Research. Please proceed.

I have two quick questions. If we take a step back and consider the demand trends and optimization trends in your markets, are we past the peak challenges in your sector as we move forward from this quarter? You were among the first to secure monthly contracts and possibly the first to exit some of these optimization trends. Can you provide some insights into the evolving demand patterns as we come out of this quarter? You mentioned that retention was slightly better than expected. I understand the guidance, but could you clarify that? I also have a quick follow-up regarding AI.

Yes. Alex. This is Tyler. I'll take that one. I think just in terms of the demand trends, I think they are kind of staying relatively constant, meaning that we do expect there to be continued pressure on the expansion motion and we do think there's going to be a little bit of increased pressure on churn, which is why we're saying we think net dollar retention could be 105%, 106%. We do think it will stabilize there. And a lot of it is how just the number is calculated with the year-over-year and as we kind of annualize some of the stuff that happened last year. So from that perspective, okay, we think there's still going to be a little pressure there. On the field motion, we mentioned, like we had some really good new business in the field and some really good execution and a lot of recipes for our products mean that the markets are really receptive specifically for Freshservice, and we would expect that to continue.

To provide further insight, the total addressable market in our sectors is substantial and quite fragmented. Although there are significant competitors, ample opportunities remain. Many legacy companies are not progressing as quickly as we are, and our product is constantly evolving for the better. Therefore, we have considerable growth potential. We implemented changes in our go-to-market strategy, emphasizing a more balanced approach to both inbound and outbound sales across SMB, mid-market, and enterprise segments, along with enhancing our leadership teams to foster a robust field business. These changes were initiated in Q1, and as we've mentioned, we're starting to see positive effects, though we have a long journey ahead. There is a lot of potential for growth, evidenced by an increasing number of large deals we are securing more than ever before. Each quarter, we are closing more substantial deals than in previous periods. For instance, we have set a target to close 30,000 deals within a quarter, and last quarter, we exceeded that target, with expectations for continued growth in those figures. We believe we are still in the early stages of how these go-to-market adjustments will influence our business, and we are optimistic about the future impact they will have.

It's coming from the line of Nick Altmann with Scotiabank. Please proceed.

Awesome. Thanks guys for taking the question. The margins in the quarter and the free cash flow guide was very impressive. So I guess my question is really around the trade-off of growth versus margin improvements. I know there's some one-time items this year, but some of the underlying metrics suggest that there is some level of stabilization. So I guess, with that in mind, how are you guys sort of thinking about margin leverage over the coming years in a time where things seem to be stabilizing, the go-to-market tweaks seem to be working nicely and you have a handful of new exciting SKUs coming online.

Yes, Nick. This is Tyler. I'll respond to that. You're correct. We've seen excellent performance in terms of our bottom line and margins are doing very well. We've always believed that we had leverage in our model, and we have been focusing on that. However, we want to emphasize that we are not sacrificing cash flow and profits for the sake of growth. We will continue to invest in our go-to-market strategies and in the net machine. It's important to ensure that these are efficient investments yielding the right returns. Our commitment to investing here and fostering growth will remain strong as we move into next year. We plan to discuss this further during our Investor Day on September 7, where we will provide more details. We genuinely believe there is significant opportunity across all our product lines, and we will continue to support capturing market share for those opportunities.

Thank you, everybody, for your time. This is the end of the Q&A. Thank you all for participating, and you may now disconnect.