Over the past six months, Freshworks’s shares (currently trading at $13.19) have posted a disappointing 17.3% loss, well below the S&P 500’s 16.2% gain. This might have investors contemplating their next move.

Following the pullback, is this a buying opportunity for FRSH? Find out in our full research report, it’s free.

Why Does Freshworks Spark Debate?

Starting as a customer service solution before expanding into a comprehensive software suite, Freshworks (NASDAQ: FRSH) provides AI-powered software-as-a-service solutions that help companies manage customer service, IT support, sales, and marketing functions.

Two Things to Like:

1. ARR Surges as Recurring Revenue Flows In

While reported revenue for a software company can include low-margin items like implementation fees, annual recurring revenue (ARR) is a sum of the next 12 months of contracted revenue purely from software subscriptions, or the high-margin, predictable revenue streams that make SaaS businesses so valuable.

Freshworks’s ARR punched in at $833.8 million in Q2, and over the last four quarters, its year-on-year growth averaged 21%. This performance was impressive and shows that customers are willing to take multi-year bets on the company’s technology. Its growth also makes Freshworks a more predictable business, a tailwind for its valuation as investors typically prefer businesses with recurring revenue.

2. Elite Gross Margin Powers Best-In-Class Business Model

What makes the software-as-a-service model so attractive is that once the software is developed, it usually doesn’t cost much to provide it as an ongoing service. These minimal costs can include servers, licenses, and certain personnel.

Freshworks’s gross margin is one of the highest in the software sector, an output of its asset-lite business model and strong pricing power. It also enables the company to fund large investments in new products and sales during periods of rapid growth to achieve outsized profits at scale. As you can see below, it averaged an elite 84.6% gross margin over the last year. That means Freshworks only paid its providers $15.38 for every $100 in revenue.

The market not only cares about gross margin levels but also how they change over time because expansion creates firepower for profitability and free cash generation. Freshworks has seen gross margins improve by 2.9 percentage points over the last 2 year, which is very good in the software space.

One Reason to be Careful:

Customer Churn Hurts Long-Term Outlook

One of the best parts about the software-as-a-service business model (and a reason why they trade at high valuation multiples) is that customers typically spend more on a company’s products and services over time.

Freshworks’s net revenue retention rate, a key performance metric measuring how much money existing customers from a year ago are spending today, was 105% in Q2. This means Freshworks would’ve grown its revenue by 5.3% even if it didn’t win any new customers over the last 12 months.

Freshworks has a decent net retention rate, showing us that its customers not only tend to stick around but also get increasing value from its software over time.

Final Judgment

Freshworks’s positive characteristics outweigh the negatives. With the recent decline, the stock trades at 4.4× forward price-to-sales (or $13.19 per share). Is now a good time to initiate a position? See for yourself in our comprehensive research report, it’s free.

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