Freshworks Inc. Q1 FY2024 Earnings Call

Good day, and thank you for standing by. Welcome to the Freshworks' First Quarter 2024 Conference Call. Please be advised that today's conference is being recorded. I would now like to turn the conference over to your speaker today, Joon Huh, Head of Investor Relations. Please go ahead.

Thank you. Good afternoon, and welcome to Freshworks' First Quarter 2024 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 first quarter 2024 performance and our financial outlook for our second quarter and full year 2024. 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 reach our long-term revenue goals, to meet customer demand, and to control costs and improve operating efficiency. For a discussion of additional 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 our other periodic filings with the 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 at ir.freshworks.com. 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 learn more about Freshworks. And with that, let me turn it over to Girish.

Thank you, Joon, and thank you all for joining us on this call today to cover our first quarter of 2024. We delivered solid profitable growth in Q1 as we reported revenue of $165.1 million, reflecting an increase of 20% year-over-year. We meaningfully surpassed our estimate for free cash flow, with $38.7 million in Q1 for a strong free cash flow margin of 23%. Our results reflect aspects of our growth strategy that are working, specifically in AI innovation, IT business momentum, and CSS adoption with larger customers as well as the current macro environment. Before talking about our product and growth initiatives for the business, let me start with the news we announced earlier today that we have signed a definitive agreement to acquire Device42. With more than 800 customers around the world, Device42 provides enterprise-grade IT asset management capabilities, which we believe can further strengthen our Freshservice offering. This is our first acquisition since we became a public company in 2021, and I'm excited about how this will enhance Freshservice, which is currently our fastest-growing business. With this acquisition, we will be able to provide advanced asset discovery and application dependency mapping across data center and cloud environments. Combined with our robust ITOM and ITSM capabilities, this will help IT infrastructure and ops teams track and understand their IT landscape to achieve greater efficiency in service delivery and reliability in IT operations. Through the combination, we'll be able to offer a more comprehensive solution for our customers. We have historically partnered with Device42 on large enterprise opportunities in the field. And after the transaction closes, we look forward to serving customers as one integrated team. We expect the transaction to close later in Q2. Turning to the quarter, I'm pleased with our progress across the business in Q1. First, we advanced AI innovations across our products and platform to improve agent productivity and customer satisfaction. The use of our bots with Freddy Self Service continues to strengthen deflection capabilities across customers' preferred channels. Companies, including Porsche eBike, can leverage self-service capabilities to improve personalization and provide AI-generated answers from their knowledge base. Over the past quarter, our customers have seen deflection rates of more than 40% presenting from these bots. During the quarter, we made Freddy Copilot generally available to customers, and I'm excited about the initial traction. We received early feedback that customer service agents are realizing more than a 30% improvement in their response times. While it's still early to track Copilot metrics, we are encouraged by the initial results. Mahindra & Mahindra is an Indian maker of cars and farm equipment with more than $16 billion in revenue. Their on-premise ITSM solution became complicated to manage, had a funky UI and poor self-service capabilities. The company says adopting Freddy Copilot on top of Freshservice has been a game changer. The solution article generator feature, in particular, is enabling more than 1,000 engineers to make knowledge management more efficient and enjoyable. And now the company plans to scale these products across other teams. We also saw continued momentum in our IT business with mid-market and enterprise customers. Customers are choosing us because our products are enterprise-grade with a much lower total cost of ownership, including the latest AI capabilities. A global leader in golf equipment needed to find a way to solve for its 2,000 employees walking up to the IT service desk with simple or complex problems. After deploying Freshservice, they later adopted our Freddy Self Service capabilities. With the help of our latest AI bot, the company has been able to further automate requests and significantly reduce resolution times and eliminate the lines waiting for IT help. We continue to invest in helping organizations manage their IT infrastructure and operations. In Q1, we enabled IT teams to proactively communicate the status of critical services to their stakeholders using Status Pages. This has increased trust and led to reduced incident reports during service downtime. One such customer taking advantage of this capability is the Statue of Liberty Ellis Island Foundation. With more features and improvements, we are winning more mind share with CIOs as we go after the large market opportunity in ITSM, ESM, and beyond. Turning to the CS business, adoption continues to grow for our customer service suite, our multichannel solution that combines conversational support with robust ticketing features empowered with AI. Companies like Monica Vinader and Stitch Fix are choosing CSS. Stitch Fix employs more than 5,000 people and leverages styles and AI to deliver personalized clothing and accessories to over 3 million customers. Their previous customer service solution was expensive and complicated with outdated AI technology. A long-standing Freshservice customer, Stitch Fix adopted Customer Service Suite as their solution in Q1, largely because of our leading AI innovations, including our copilot capabilities. Freddy Copilot is boosting productivity for agents as power users have seen a reduction of resolution and response times of more than 30%, and CSAT scores increased on average by more than 5%. As we continue to improve productivity from these agents, we believe this will lead to higher adoption within organizations and more expansion opportunities. This quarter, we introduced sentiment analysis for real-time insights into the emotional tone of customer interactions. We also added generative AI-led quality management capabilities like article suggestions and auto completion to help support teams deliver superior responses. Within one quarter, these capabilities generated over 38 million interactions. Finally, I want to acknowledge today's news that I'm transitioning into an Executive Chairman role at Freshworks, and Dennis Woodside, currently Freshworks' President, will assume the Chief Executive Officer role. I'm incredibly proud of what we have accomplished at Freshworks since I founded the company 14 years ago. We are the first Indian SaaS company to be listed on NASDAQ, a true friend to more than 67,000 customers around the world, and home to our 4,900 strong global workforce. Our business is strong, and we have a fantastic platform to launch Freshworks into a sustainable and growing public company. Through these 14 years of building and scaling Freshworks, our hiring philosophy takes inspiration from an ancient poem from Tirukkural, written by a Tamil poet and philosopher Thiruvalluvar 2,000 years ago. Translated in English, it means find the right person with the skills and resources to finish the job and empower them to do it. After seeing this play out beautifully over the years, the time has come to apply this to the CEO role at Freshworks, and I'm fully confident that Dennis is the right leader to step into the CEO role. His deep understanding of the Freshworks business, his admiration and respect for our Indian roots, ability to attract world-class talent, and the operational excellence he has brought in to Freshworks over the last 18 months gives me the confidence to pass over the baton to Dennis, and I look forward to being his trusted adviser in my new capacity to help make Freshworks software available to the Fortune 5,000,000. Going forward, I look forward to working with our product teams to drive our AI vision and long-term product strategy. I would like to thank the entire Freshworks team for all the support they have given me over the years. And for delivering another solid quarter as we continue on our mission to deliver modern AI-powered customer and employee service solutions that increase efficiency and improve engagement for companies of all sizes. I would like to congratulate Dennis, and now turn it over to him to share what we are seeing in the marketplace, how larger customers are driving our business growth, and how companies are expanding the use of our products.

Thank you, G. I am honored to build on what G started 14 years ago. What he has created is truly special. Our mission and strategy remain the same. We stand before extraordinary opportunities and have the right foundation to make it possible, a winning combination of our strong delighting customers and our product innovation. I'm committed and excited to continue our journey of growth. As G mentioned, we efficiently scaled the business in Q1. With revenue growth of 20% and strong free cash flow margins of 23%, we exceeded the Rule of 40 for the quarter. We continue to see momentum with larger customers choosing our enterprise-grade solutions. In Q1, customers paying over $50,000 in ARR grew 29% to 2,593, representing 49% or nearly half of our business. Our solutions provide enterprise-grade capabilities combined with consumer-level usability to address the needs of large complex organizations. For example, Cineworld Group is the world's second largest cinema chain, with more than 700 movie theaters across the U.S., U.K., and other countries. Their prior customer service solution wasn't allowing them to respond to queries fast enough and gain insights into their customers' experience. They adopted Freshdesk across their Cineworld, Picturehouse, and Regal customer service teams. Now the company can quickly identify and respond to customer queries, understand root causes and develop better steps to resolve them using the power of Freshworks. I'm also very excited about entering into a definitive agreement to acquire Device42. We believe this acquisition will help us win more mid-market and enterprise customers as advanced ITAM capabilities for discovery and dependency mapping are becoming a critical part of the IT purchasing decisions for large customers. With this acquisition, we intend to build on the upmarket momentum and success that we're already seeing with Freshservice for IT customers. Turning to expansion. In Q1, net dollar retention was 106%, and customers using more than one product was 26%. We saw notable expansion and multiproduct activity from Freshservice for business teams. We're also executing on the cross-sell of our 2 largest product areas in IT and customer service. An example of cross-sell is Dark Matter Technologies. Dark Matter employs more than 1,000 people and makes software that enables retail banks, credit unions, and credit vendors to simplify lending. Already a Freshservice customer for ITSM, they chose Customer Service Suite to replace their incumbent solution because it was easy to go live within their tight time frames and simple to configure. We remain bullish on the AI opportunity. We believe this will be a tailwind to our business, and this is a big part of our future growth strategy. As G said, we saw promising signs of momentum from Freddy Self Service and Freddy Copilot in Q1, with over 30% improvement in productivity metrics for our customers. This has led to early signs of monetization since the Freddy Copilot add-on became GA this past quarter. From a market demand perspective, we continue to see the impact of a challenging macroeconomic environment. While Q4 saw an uptick in expansion activity, we saw pressure on overall expansion rates for Q1 across our customer base in terms of agent growth. For the SMB part of the market, where we attract customers through an inbound digital motion, there is still work to be done to improve this motion. We're seeing lower expansion rates and a lower number of net new customer adds as the macro economy is having a meaningful impact on this part of our customer base. This led to slower growth for the CS business as the majority of the business is from SMB. Given this current market environment, it's important for us to maintain a balanced approach to our investments. In Q1, we were able to create further efficiencies while investing in the business to drive future growth.

Thanks, Dennis, and congratulations, and thanks to all of you joining on the call and via webcast. I'm pleased with our ability to deliver another quarter of durable growth while improving our profitability. All the operational improvements that we implemented last year have created positive business momentum that carried into this year to drive further efficiencies and strong margin expansion in Q1. For our call today, I'll cover the Q1 2024 financial results, provide background on the key metrics, and close with our forward-looking commentary and expectations for Q2 and the full year 2024. I'll include constant currency comparisons for certain metrics to provide a better view of our business trends. 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, total revenue in Q1 grew 20% to $165.1 million on a reported basis and 19% adjusted for constant currency. Professional services contributed approximately $2.6 million to total revenue, which is a lower contribution percentage than prior quarters. This is intentional as we are shifting more services revenue to our partner network. We continue to see momentum in our IT business, specifically for new deals for mid-market and enterprise customers. We're also seeing upmarket traction from the CS business as our largest expansion deals in Q1 were from our customer service products. Moving to margins, non-GAAP gross margin increased to 85% as we continue to drive efficiencies in our infrastructure spend as we scale the business. Compared to the prior year, this represents an improvement of more than 200 basis points. We also improved our non-GAAP operating margin to 13%, as non-GAAP operating income came in at $21.8 million, which includes a one-time benefit of $3.7 million related to employee benefits expenses. Adjusting for this one-time benefit, non-GAAP operating margin would be 11% and still ahead of our prior expectations, as we made ongoing operational improvements and shifted some marketing and legal spend into future quarters. As we've talked about previously, our financial model was built for us to make investments in our many growth initiatives. At the same time, we have flexibility in the model to adjust our spend as we see demand change throughout the year to prudently manage our expense base and drive efficiencies. Moving to operating metrics, our 2 key business metrics are net dollar retention and customers contributing more than $5,000 in ARR. Net dollar retention came in line with our expectations at 106% in the quarter, both as reported and on a constant currency basis. While our customers continue to grow their spend for our products in Q1, we did not see the same elevated levels of large expansion deals that we saw at the end of last year. Overall churn modestly increased and continues to remain squarely in the mid-teens. Looking forward, we're planning for a Q2 net dollar retention range of approximately 105% to 106%. For our other key business metric of number of customers contributing more than $5,000 in ARR, this metric grew 11% year-over-year to 20,549 customers in the quarter and now represents 89% of our ARR. On a constant currency basis, this customer metric grew 12% year-over-year. For our larger customer cohort contributing more than $50,000 in ARR, this cohort grew 29% year-over-year to 2,593 customers and now represents 49% of our ARR. The constant currency growth rate for this quarter was also 29%. For total customers, we added approximately 400 net customers and ended the quarter with over 67,500 customers. The lower net adds over the past 2 quarters have largely been a result of a lower number of our new CS customers, especially in the SMB. For the past few quarters, we have been focusing our efforts and go-to-market spend to target higher-yielding customers, which is resulting in ongoing increases in ARPA. Now let's turn to calculated billings, balance sheet, and cash items. Our normalized calculated billings growth was 17% in Q1, down 1 percentage point from the 18% normalized growth rate in Q4. As we've talked about before, billings growth rates can fluctuate quarter-to-quarter due to a number of factors. In Q1, we had a negative impact primarily from lower early renewal activity compared to the prior quarter resulting in an as-reported calculated billings growth rate of 14% or $174.7 million. Looking forward to Q2 2024, our initial estimate for calculated billings growth is 12%. For the full year 2024, we expect calculated billings growth to be approximately 16% or approximately 1 percentage point below our annual revenue growth. Moving to our cash items, we meaningfully outperformed our free cash flow estimates coming in at $38.7 million for Q1. This was a result of strong collections activities and an ongoing focus to drive efficiencies on our spend around head count and vendor costs. Given our strong cash flow performance in the quarter, we are increasing our full year 2024 estimates to $125 million, with approximately $28 million in Q2. We ended Q1 maintaining a similar balance with prior quarters for cash, cash equivalents, and marketable securities with $1.2 billion. We continue to manage and offset some share count dilution by net settling invested equity amounts and using $23 million during the quarter. As a reminder, this activity is reflected in our financing activities and is excluded from free cash flow. We plan to continue net settling vested equity amounts going forward, resulting in Q2 cash usage of approximately $15 million at current stock price levels. For the year, we expect to use approximately $70 million to net settle vested equity amounts. Turning to our share count for Q1, we had approximately 322 million shares outstanding on a fully diluted basis as of March 31, 2024, representing a share reduction compared to the prior year and quarter. The fully diluted calculation consists of approximately 299 million shares outstanding, $21 million related to unvested RSUs and PRSUs, and 2 million shares related to outstanding options. Let me now provide our forward-looking estimates. I'll go through the numbers first and then provide background commentary afterward. For the second quarter of 2024, we expect revenue to be in the range of $168 million to $170 million, growing 16% to 17% year-over-year; non-GAAP income from operations to be in the range of $6.5 million to $8.5 million; and non-GAAP net income per share to be in the range of $0.05 to $0.06, assuming weighted average shares outstanding of approximately 305.6 million shares. For the full year 2024, we expect revenue to be in the range of $695 million to $705 million, growing 17% to 18% year-over-year; non-GAAP income from operations to be in the range of $58 million to $64 million; and non-GAAP net income per share to be in the range of $0.32 to $0.35, assuming weighted average shares outstanding of approximately 307.6 million. Our forward-looking estimates are based on FX rates as of April 26, 2024. So any future currency moves are not factored in. We want to provide our best view of the business today in a changing market environment. So here are a few items to call out. First, on the Device42 acquisition, our forward-looking estimates do not include numbers from the Device42 acquisition. We'll cover details of the financial impact from the acquisition after closing. That said, we expect the transaction to be accretive to our revenue growth for this year and have minimal impact on our free cash flow estimates. Second, our full year 2024 revenue estimates, compared to our prior estimate, the current estimates include negative adjustments of approximately $2 million related to FX moves since last quarter and negative $1.3 million related to the intentional shifting of professional services revenue to partners. Third, our Q2 operating income. As a reminder, we have seasonality in our business as Q2 expenses normally step up as the annual merit increases take effect, leading to lower margins quarter-over-quarter. Let me close by saying we're very focused on growing the business while creating a durable profitable company to deliver long-term value for our stakeholders. We're innovating on our products, especially in the area of AI. We're building business momentum and gaining traction with larger customers, and we're driving efficiencies in the business that's reflected in our financial results. We're excited about the many opportunities ahead. And with that, let's take your questions.

Our first question comes from Scott Berg with Needham & Company.

Dennis, congrats on the move to the CEO role, and G, I still hope we get a chance to speak with you going forward here. I guess a couple of things for me. I believe it was Dennis who called out the kind of softness in the CS market, especially downstream in the SMB segment. There's a pretty popular narrative out there on the impact that whether it's customers of yours or others in the space trying to use different AI tools to automate some of the labor out of some of these customer service environments. Are you seeing that impact your business at all in the quarter? And is there anything related to the slight reduction in full year revenues maybe because of any changes there in terms of how your customers are using the technologies?

Thanks, Scott. It's Dennis here. We view the first quarter for small and medium-sized businesses as a continuation of the trends we highlighted in the fourth quarter. Throughout last year, we noticed that SMBs were under pressure from the macro environment, particularly due to rising interest rates which are hindering their ability to grow their businesses. This directly affects their investment and customer support. We observed a decline in our net additions, which has been apparent over the past year. However, this has been balanced by growth in IT and among larger clients. This is evident in the continued growth of our $50,000 and up customer segment. Do we anticipate AI to influence our business in the long run? Yes. Meanwhile, the adoption rate of our AI solutions has been robust. We launched Freddy Copilot into general availability around the middle of the quarter, and although it's still early, we noticed good uptake from both the SMB segment and larger customers. It's premature to attribute the SMB weakness solely to AI; that trend existed before this quarter, but we certainly observed it this quarter.

Understood. Helpful. And then, G, you're moving into the Executive Chairman role. Some are going to see this as kind of a surprise and a little bit sudden given the way the announcement was worded, at least, without a kind of formal transition. And I realize you're not going anywhere. But why is the time right today to make this change versus the beginning of the fiscal year 3, 4 months ago or maybe later on this year?

Thanks, Scott. I want to clarify that this was planned as part of my succession even when we brought Dennis on board 18 months ago. Our expectation was that he would eventually take over my role. We have been working together with Dennis helping Freshworks enhance operational efficiency, build a top-notch team, and concentrate on go-to-market strategies while I focused on AI and product strategy. In short, we are leveraging our strengths. I have always believed in playing to our strengths. We feel it is best for Freshworks for me to concentrate on long-term product strategy and AI, while Dennis, with his outstanding background, particularly from Dropbox where he scaled the company significantly in a short time, brings the right expertise. This was the plan all along, and I am confident that this is the right moment to implement it.

Yes. Just Scott, just a little more on that. I think first of all, the hardest thing in business and in technology is to build a company out of nothing and scale it to a point where you have line of sight to $1 billion in revenue, you're serving tens of thousands of customers around the world, and G did that. And the advantage, we really have been operating in many respects in a way where G has been focused very much on technology, very much on the AI initiatives and what's coming. And I've been focused on the near term and what we need to do to scale the business. So to some degree, we've been operating in a way that's consistent with where we're headed for some time. Obviously, this formalizes it in a meaningful way. But I think internally, it wouldn't be viewed as a sudden change necessarily. And we're excited about taking it forward from here.

Our next question comes from the line of Pinjalim Bora with JPMorgan.

One question on the performance on the low end of the market. Is it possible to delineate between how much of the underperformance there is because of the worsening macro environment versus some of the changes in the go-to-market side that you put into place earlier in the year? And did I hear it correctly? Is it mainly on the CX side versus ITSM?

Thank you for the question. The changes we've implemented in our go-to-market strategy over the past year mainly focused on the field, which did not significantly impact our SMB performance. We previously mentioned that we are working on improving lead conversion in the SMB sector by adopting a different approach to servicing and selling those leads. We have made some progress and expect this to yield positive results over time, although we are also facing challenges due to macroeconomic conditions in that segment. It can be difficult to separate the effects of the macro environment from other factors. However, customer feedback indicates they are under pressure, leading to extended decision-making processes and, in some cases, a lack of decisions altogether. For us, the SMB market is primarily a customer success business, so when we refer to SMB, we are mainly speaking about customer success. This is where we are noticing weakness in SMB and customer success.

Yes. Understood. One high-level question, so a little bit long-winded. But if I think about the bot-based products in the market today that might handle, say, L1 queries and the copilot kind of products which sits beside an agent, how important is that context switch between these 2 layers for kind of the success of the efficacy of the AI? Trying to understand if a company uses L1 from one vendor and L2 for another vendor, does that actually increase the work for the company to create the plumbing between the 2 layers and maybe has an effect on the overall efficacy or success rates?

Yes. I'll take that, Pinjalim, this is G. So first of all, when you look at it from a customer experience standpoint, we all know that customers hate to repeat themselves when they call the call center and they are passed around, right? So it's the same customer experience at the core here. So when the customer is actually being helped by a bot and let's say, for some reason, the bots are not able to help handing off the customer gracefully to an agent who has full context is really important. That's something where at Freshworks with our new Customer Service Suite, we have a complete omnichannel product that combines bots with human experience and ticketing for longer-standing use cases. So if a company is using a different technology for bots and a different technology for human agents, they can still integrate and transfer that context, but they would have to do that extra work. But it's always important for the human agent to actually have the context of what transpired before the customer came in contact.

Our next question comes from the line of Alex Zukin with Wolfe Research.

This is Ethan Bruck filling in for Alex Zukin. I appreciate the insights regarding the customer service aspect. I'm curious whether the ITSM met or fell short of your internal expectations. Also, thank you for elaborating on the various factors affecting the updated 2024 guidance. Can you clarify if you believe it is now less risky and share any additional considerations on how to approach it?

I'll take the guidance part and then I can hand it to Dennis for the ITSM piece. But I think you're asking for further clarification. What we did call out is like guidance for the year, obviously, it's based on what we see today and how we expect to perform. Nothing from the Device42 acquisition is in there. But there is about, just on the $3.5 million impacting for the year, $2 million on FX and almost $1.5 million on professional services. Professional services we commented on. This is a very prescriptive shift to partners, and we're actually pretty excited about that. It's just that we had expectations of services revenue. A lot of that we were taking the paper and they're giving it to the partners. And so we saw both sides on the margin and on the top line revenue, which has actually come down because now we have partner stores having the capability to go deliver it themselves. I'll let Dennis answer the other piece.

Our ITSM business continues to perform very well, especially among larger customers in the field. The ideal clients for our ITSM offerings are companies with 500 to 20,000 employees that have complex IT requirements. These businesses usually have over 100 agents in their IT departments and multiple systems that our products must integrate with. They seek a scalable solution that addresses their needs across ITSM, ITOM, ITAM, and ESM for departments outside of IT. We have established a strong position in this market as a credible alternative to ServiceNow. We are cloud-first and currently operate at an enterprise scale, with many customers supporting workforces of 10,000 to 20,000 people using our products. An example this quarter is Mahindra & Mahindra, a $16 billion industrial company in India, which was drawn to Freshservice for its AI capabilities in IT. Our IT business is performing well, as we highlighted during our Investor Day in September, where we reported strong growth rates in the high 30s. We are continuing to invest in this area. The acquisition of Device42 was appealing to us as we see an increasing number of customers searching for advanced asset management capabilities, making their ITSM purchasing decisions alongside how they will manage their IT assets. Overall, IT is doing quite well for us, and we are committed to furthering our efforts in this business.

Our next question will come from the line of Brent Thill with Jefferies.

Dennis, congrats on your new role. I was just curious to your thoughts on the 1 or 2 things that you want to focus on in your new role. And just a quick follow-up. I know a number of vendors have been commenting on SMB concerns. But I think historically, there has been some separation between macro and internal execution. And I'm curious, do you feel the internal execution is where you'd like it to be? Or do you feel this is all macro and there's nothing you can really do right now?

Thank you for the question. My primary focus is on executing our current business strategy, particularly in relation to small and medium-sized businesses. We can improve and need to change our approach in this area. I've mentioned this before at our Investor Day and throughout the fourth quarter. We are modernizing our inbound and digital-led processes, as there is room for improvement to meet customer expectations. Currently, our process is overly manual, and we need to leverage AI to streamline it. It's crucial that customers can easily recognize the value of our products. Therefore, our focus is on execution not only in the SMB sector but also in the field. The changes we’ve made over the past year aim to establish a solid foundation for execution, including hiring the right people to help us scale. Additionally, we are concentrating on moving further into the mid-market and the lower end of the enterprise segment. This shift demands new strategies for selling, supporting, and providing professional services, as well as real innovation in AI. These elements continue to be a priority for G and me as we refine our efforts. Regarding your last question, I believe the macro environment is certainly a factor, and I agree we can do more to address these challenges.

And just a quick follow-up, Dennis. When you think about that modernization of a digital motion, I mean how long does that take to complete? Is that a 2024 event? Is it going to be complete in the front half? How do you think about the actual timing of it?

It's a '24 event. And the expectation is that we start seeing impact later this year.

Our next question comes from the line of Rob Oliver with Baird.

Great. I'll add my congratulations, Dennis, to you, and G, to you as well. Dennis, my question is for you. And I know you commented that it's too early to say that generative AI is the reason for the agent weakness in Q1, but maybe harking back to Scott's question at the outset. You also said that you're seeing early signs of Freddy monetization. So I'd be curious to hear what sort of impact that is having within your accounts in terms of, I guess, seat and agent activity as well as this came up in conjunction with Klarna. Sort of the distinction between Level 1 and Level 2 deflections, I mean we would expect that line to shift. So curious to hear your view on that. And then I have a follow-up for Tyler.

Yes. On AI, in every sale or renewal we are involved with, AI is central. Every customer wants to discuss our AI capabilities and roadmap, and how it can assist them. They are looking for examples. Currently, we have two ways to monetize. One is through Freddy Self Service, which is Level 1, and the other is via the Copilot, which supports agents. These have different pricing models: one based on consumption, and the other on a price per seat. Both options are attracting significant interest and are contributing to sales in various ways. In some instances, we are monetizing directly, with customers paying upfront. In other cases, we use our AI capabilities to help close deals. A notable example is Stitch Fix, which purchased not only for the core customer support platform but also based on the Copilot and AI roadmap. Moreover, in certain situations, we view AI as an adoption strategy, aiming for customers to use AI comprehensively across all their agents. We provide it for free or at a reduced cost for a limited time, intending to monetize later. It's still early days; our Copilot was launched in general availability in the middle of Q1. However, the interest and usage from customers is evident when they start using it, and the potential value for the customer is promising.

Great. Very helpful. And then, Tyler, I was just wondering if you could give us a little bit more color just on the sort of billings expectations in linearity throughout the year. Obviously, a solid quarter this quarter, it's going to drop off fairly meaningfully. I just wanted to get your sense for kind of the linearity there and what gives you the confidence in the better billings outlook sort of later in the year.

Sure. Yes, of course. We said normalized billings for Q1, 17%, 14% as reported, and we said 12% for Q2. That's an as-reported number, and our expectation is that would normalize up. What happens is Q2 of last year, we actually had a pretty decent amount of pull-ins from Q3. We always have pull-ins like early renewals with expansion, and we kind of have an expectation about that, but it's a little bit unpredictable. And so right now, 12% un-normalized, and we do expect a little bit of pull-in. But that one again, we'll have a much better view at the end of the quarter. For the year, 16%, yes, the numbers fall out and we can see the billing schedules going out. That's what we expect for the year in line with the guidance that we gave, which does assume there's going to be a little bit of acceleration, but we can already see some of that in the numbers.

Our next question comes from the line of Ryan MacWilliams with Barclays.

Great to hear about the 30% improvement in productivity from your customers using Freddy AI. I'm curious if there were any other key takeaways after Freddy Copilot became generally available, such as how the transition has been in converting the beta customers, which I believe numbered around 2,500 in the third quarter, into paying customers.

Thanks for the question. It's Dennis. What’s been interesting to see is that there is strong conversion and interest across all customer segments, both small and large. We are seeing a surprising number of small and medium-sized businesses who are new to Freshworks signing up directly for AI from the start. They try the product for a limited time, recognize its value, and then decide to pay for it. The pricing is holding up well. The small and medium-sized business segment has been surprisingly robust. For larger customers, however, they are at different stages of their adoption process. Some are fully committed from the beginning, while others are taking more time to evaluate data and security implications, leading to a longer review process. Nonetheless, every customer is interested in discussing it, which is exciting and provides a lot to discuss during renewals with existing clients. Additionally, AI is at the core of our pitch to every new prospect we engage with.

Right. Understood. And how does the trajectory for rent retention look like here? Anything to call out from upsells, churn, or seat that's worth noting, maybe what's implied for the 105%, 106% guide for 2Q?

Nothing is implied there. I think what we're seeing there is very similar to what we saw in Q1, so kind of what said, 106%. It came in at 106%. Churn, we said ticked up slightly but not materially enough to round to anything. We've already done a really good job at bringing down our gross churn over the past couple of years. The expansion motion, as we've talked about in the past, we're very, very focused on how we're expanding with our customers outside of agent addition. Agent addition is still the #1 expansion motion for us, and a lot of that is organic. But as we've talked about that, that rate has decreased over the last couple of years. What we are seeing is a good pickup of some of our newer products. And then Freddy Copilot, in particular, there is actually some good add-on business there. But nothing that is going to move the needle higher than the 105%, 106% for Q2. For the year, we expect it to be roughly the same, in that 106% range.

Our next question comes from the line of Dan Reagan with Canaccord Genuity.

This is Dan Reagan on for DJ. First, I just wanted to ask if you could elaborate on the expected synergies from the Device42 acquisition. So you've historically partnered with Device42 on large enterprise opportunities. So I'm just wondering how you're thinking about the go-to-market synergies from here beyond what you've been seeing. And then sort of how it positions Freshworks with your upmarket ambitions. Maybe any nice cross-sell opportunities with its 800 customer base? Any color there would be awesome.

Thanks for the question. So we see Device42 in a couple of ways. First of all, we've been partnering with them for the last 18 months. So we have a product integration that allows an ITSM customer to easily flip into the Device42 environment. We've been co-selling with them to large customers. We called out one of the customers last quarter was a large apparel retailer. Device42 was integral to that sale. I was in Europe earlier last week, and one of our larger customers, we are now up-selling Device42 in. And so we know that the product works. We know that our customers, especially these larger customers, they want to buy ITSM alongside a sophisticated ITAM solution. We've seen the product in action. So we feel like we've derisked product market fit. They have 800 customers worldwide; most of those customers do not use Freshservice as their ITSM. So we see synergies in a couple of different ways. As those ITSMs come up for renewal, we will know that they're up for renewal. We'll be able to get in front of those decision-makers and make a pitch and win some business there. And then amongst our thousands of customers, most of them don't use an advanced ITAM solution from Device42. So we will have a programmatic approach to selling advanced ITAM into our existing base. So I think those are 2 areas. And we definitely see a need for more advanced capability than we currently have among larger customers. So for us, it eases this move upmarket. It puts us in a better position vis-a-vis ServiceNow and Atlassian in particular, which have more in-depth ITAM solutions than we did natively, which is why we pursued the acquisition.

Excellent. Super helpful. And then just one follow-up. With the transition of Girish EC and Dennis assuming the CEO position, congrats there. You've already provided a bit of color on this, but could you dive a little bit deeper into any changes in strategic initiatives and operational focus? You're focused on the low end, improving SMB conversion that's been discussed. At the high end, you have momentum, but now a newer focus with opportunities around Device42. Any color there on initiatives and any changes would be awesome.

Yes. So no changes from what we said before. Really focused on that SMB opportunity in getting that business back to healthy growth. Focused on continuing to drive upmarket, which is primarily IT. Focused on the AI opportunity, which is across all of our products. Those are the things that are really driving our business now. And then lastly, just focused on continuing our expansion motion, expansion, cross-sell, and upsell as we have more products. Now we have Device42, that's another product that we can cross-sell into our existing base.

Our next question comes from the line of Pat Walravens with Citizens JMP.

Great. Dennis, it's Pat Walravens. I would like to revisit the agent replacement discussion. Let me share a quick story and then I’m interested to hear how things might differ or be similar for Freshworks. I talked to a large company using another vendor that has a few thousand agents. They're planning to implement the AI option from this vendor, which will significantly reduce their number of agents, possibly by half. I asked if that meant their contract value would decrease, and they replied that the total contract value is actually increasing. This vendor is shifting to consumption pricing, which is already included in the plan. They don't mind paying more for software since they're saving so much on labor, making the increase in software costs much smaller compared to labor savings. Does this dynamic apply to Freshworks, or is it different?

Pat, this is Girish. So this is exactly the same dynamic, and we had already also explained it earlier. So see, we all know that customer service automation is something that businesses want, and it's not today after gen AI, it's been something that businesses want right from the day they started putting in IVRs and call centers, right? So this has been a journey for us. And of course, gen AI is accelerating that, and our Freddy Self Service is also built to capture and leverage that. As you clearly stated, for the customer, it's a win-win because by investing in technology, they are saving a lot more in terms of overall not having to hire so many people. And that translates into a better revenue realization potential for Freshworks also. That's exactly true.

And so are you able to increase the size of the contracts overall on the renewals?

Yes.

Yes. So again, it's early days, but what you're describing is exactly what we're pursuing. And that's what you're talking about with respect to reduced agent count. Where that happens, we're basically replacing human costs with software costs. And so our customers are on that exact same wavelength. Not all of them are looking to reduce staff. But for those who are, there's absolutely a business case to be made for spending more on the software. Remember, we have a consumption product. That's what Freddy Self Service is. You pay by session, which is basically the equivalent of a ticket. And they understand that language; they understand how to monetize the ticket or what the ticket costs them, so they're willing to pay on a consumption basis for avoiding that human interaction.

Our next question comes from the line of Elizabeth Porter with Morgan Stanley.

Great. I wanted to ask a bit more of a macro question. The macro headwinds deal hesitancy has been an impact really across software. So I wanted to get your view on how customer conversations are trending with customers as it relates to just how long deals can be pushed off. And how does that balance with this rush to invest in AI and not wanting to be left behind? Kind of any sort of view on when that pendulum and shift back to customers being more willing to engage in deals would be super helpful for your view.

Well, as I said earlier, that we're seeing 2 different trends. In the larger account space, which for us is in that $500 and up cohort, we're seeing good momentum. We're seeing a lot of interest. We're seeing a lot of deals, and you're seeing that in our numbers overall. As our customer base continues to shift into larger relationships with us, higher ARPA, that tends to be on the IT side of the house, but not exclusively. Because some of the deals that we talked about this quarter like Stitch Fix are customer support deals. It's SMB, where, at least for us, we're seeing the kind of headwinds that you're talking about, the prolonged decision-making, and the no decision, etc.

I'll address the latter part of that question. As we mentioned, we've been collaborating with Device42 for a while. We've been reselling their product, but it's primarily on a limited scale. However, we understand that it integrates well with our customers. At our Investor Day, we highlighted that we have over 8,600 Freshservice customers who each pay us more than $5,000 annually, while Device42 has around 800 customers. Very few of the 8,600 are currently using Device42. We anticipate significant synergies from this partnership, and that's the aim of this deal. We believe this is an investment in Freshservice, which has been performing exceptionally well and is well-positioned. We also recognize that lacking capabilities like those of Device42 has hindered our competitiveness in the higher enterprise sector. Therefore, we expect this partnership will help bridge that gap, as we've identified deals we've lost due to this limitation. We anticipate that this will contribute positively to our revenue, although we don't have specific figures to share at this moment; we will provide those after the deal closes. We did mention earlier that it is likely to be revenue accretive for the year and we expect it to be cash flow neutral as well.

Thank you. This concludes today's conference. Thank you for participating. You may now disconnect.